The Worst Money Move That Feels Smart in a Recession
During a recession, people want to make safe decisions with their money. This leads many people to use their savings to make additional payments against the principal on their mortgage.
Using savings to pay down your mortgage is a dangerous financial decision during a recession. Even though it feels like a safe move, it is actually risky because it reduces your liquidity while doing nothing to improve your monthly cash flow.
In a recession, cash is a lifeline
In the past, I’ve written about why a recession is the worst time to pay down debt.
The argument is straight forward.
The time to pay off debt is when the economy is strong, and you have the highest level of job security.
When the economy goes into recession, many firms will layoff workers to conserve money.
That means, for most people, the time they are most likely to lose their job is during a recession. At the very least, we can confidently say that overall job security decreases during recessions.
The lower your job security, the more valuable every dollar you have saved becomes.
Every dollar you pay against your debt, beyond the minimum payment, is a dollar you don’t have for essential spending like groceries if you lose your job. Which, as we just discussed, becomes increasingly more likely during a recession.
My advice was simple if you feel like you are about to lose your job; it’s time to cut back on all non-essential spending, which includes making anything beyond the minimum payments on debts. This allows you to save as much cash as possible to cover your essential living expenses if you are forced to go without income for a while.
This idea made some people angry
When I detailed the reason why paying down debt during a recession is a bad idea, I was surprised by how many people angrily disagreed. Many wrote in all caps about how clearing debt should be the number one priority in a recession.
The argument these commenters put forward was that by only paying the minimum payment on your debts, it would take longer to clear those debts, and you would pay more in interest over the long run.
Of course, it is true that the longer it takes you to pay off a loan, the more interest you will end up paying.
Everything has an opportunity cost.
Holding onto more cash provides additional financial security in case you lose your job. The cost of that increased security is that you end up paying more interest.
Aggressively paying off your debt means you will pay less in interest. The cost of that reduced interest is if you lose your job, you will have less money to cover your living expenses.
Ironically, focusing on paying off your debt during a recession could lead to a scenario where you end up paying much more in interest. If you are unable to clear your debts completely, then lose your job, and have no savings, you may not be able to even make your minimum payments on your loans. Then you get hit with penalties and may have your debt sent to a collection agency.
When I say a recession is a bad time to pay down debt, I am speaking from a risk management perspective.
Making additional mortgage payments is the riskest decision that most people consider “safe” in a recession
Many people would agree that paying off your mortgage early is a smart idea. I prefer to invest my extra money rather than pay down my mortgage because it gives me a better chance to maximize my wealth. That being said, if you can’t stand having a mortgage, paying it off quickly can make sense.
The only time that it is unarguably a terrible decision to pay extra money against your mortgage is during a recession, or you think you are about to lose your job. This is true for three reasons.
It will reduce your liquidity.
It does not improve your cashflow.
It is the debt with the lowest balance.
Making extra mortgage payments reduces your liquidity
Liquidity is a fancy finance term that simply means having cash available to you. The only way to truly “recession-proof” your finances is to have lots of cash on hand that you can draw down if you ever lost your job.
My wife and I keep enough cash on hand to cover one year’s worth of living expenses, assuming we tightened our belts and scaled back some non-essential spending. Thankfully, neither of us have lost our jobs in the current recession, so we have not had to draw down on those cash reserves.
If we were dealt the worst hand possible, and both of us lost our job at the same time, we would be able to get by for a year, even if we had no income coming in. That is a relatively high level of liquidity that acts as an insurance policy against losing our jobs.
Let’s say you took $50,000 in cash and decided to throw it against your mortgage. Once that money is paid against the mortgage, you cannot access it again. Yes, you just substantially reduced your mortgage balance, but we have given up your liquidity.
Making extra mortgage payments does nothing for your cash flow
After liquidity, the most critical factor that will determine how easily you get trough a recession is your monthly cash flow. Cash flow simply is simply the difference between your monthly income and expenses.
Unless you pay it off completely, throwing money against your mortgage does nothing to improve your monthly cash flow.
If you have a $300,000 mortgage and you throw $50,000 in cash against the balance, that will have no impact on the amount of your monthly payment. If your payment was $1,500 before you made the extra payment, it would still be $1,500 after.
Yes, a greater portion of that $1,500 will go towards principal rather than interest, but it has no impact on the amount you need to pay each month.
Using extra cash to pay down your mortgage just reduced your liquidity and did absolutely nothing to help your monthly cash flow. That is a decision that could come back to haunt you if you were to lose your job during the recession.
Mortgages have a lower interest rate than any other debt
The primary benefit of using cash to pay off debt is that you pay less in interest. If you’re paying off debt with a rate of interest like a credit card or even a car loan, those savings could be substantial.
For most people, the interest rate on their mortgage is substantially less than any other type of debt.
Let’s return to the example of using $50,000 in cash to pay down a $300,000 mortgage. If the interest rate on that mortgage is 3%, you would have saved around $1,500 in interest over the next year.
The cost of saving $1,500 in interest was giving up your liquidity, which, if you were to lose your job, becomes much more valuable.
In a recession paying your mortgage feels safe, but is actually risky
Under normal economic conditions, paying off debt reduces your financial risk and is a smart decision.
During a recession, the chance of you losing your job increases. Having access to cash (liquidity) can be a financial lifesaver and help you ride out a recession or job loss.
Since paying off debt, means giving up liquidity, a recession is not a good time to begin getting aggressive on paying off your debt.
Making extra payments on a mortgage is an especially risky decision because not only are you giving up liquidity, it does nothing to help your cash flow.
If you completely clear a credit card, you may have given up liquidity, but at least you no longer have a credit card payment, which helps your monthly cash flow.
Given the size of most mortgages, it’s less likely your extra payments will allow you to pay it off completely. Making additional payments on a mortgage means you have given up your liquidity and done nothing to improve your cash flow.
Losing your job, having no cash available, and still having to make your monthly mortgage payment is a recipe for financial hardship.
During a recession or anytime you feel you might lose your job, hold onto all the cash you can. When the economy recovers, then go ahead and start paying down that mortgage.
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This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any significant financial decisions.