Ask Dr. Don By Don Taylor, Ph.D., CFA • Bankrate.com

Prepay mortgage with emergency fund?

Dear Dr. Don:
I have a question for you regarding a smart money-saving move. Like many others, I have put aside several months of expenses for a rainy day. The rate I am earning on my rainy-day fund is dismal.

Why wouldn't I send my mortgage company several months worth of payments? My coupon book allows for me to specify how many months of payments I am sending. From my viewpoint, I can earn 5.375 percent on the advance payments I send them, vs. 1 percent in a passbook. I am thinking of limiting the advance monthly payments to 2003 only.
Scott Savings

Dear Scott,
If you make additional principal payments the loan balance is reduced, but the obligation to make next month's mortgage payment doesn't go away. What you're describing is to send in a few months worth of mortgage payments, so you'll have a cushion of that much time before your next mortgage payment is due. You then continue to make monthly payments keeping the cushion available until you may need it in a financial emergency.

This isn't a good idea on several levels. First, you're assuming that your financial emergency deals with you not being able to make the mortgage payment. You may have three to six month's cushion on your mortgage, but you're only freeing up one month's payment at a time in your monthly household budget. That may not be enough liquidity to get you through your financial problem.

Your mortgage servicer appears to have a system that can accept these multiple payments, but you'll need to be sure that they are credited to your account as early payments and not as additional principal. There could be problems if your loan's servicing is sold to another company.

I understand how you think you're earning the mortgage rate on these early payments but don't see how you expect to realize these savings. You're not making additional principal payments, so your interest expense isn't going down. Taken to the end of the loan you make your last mortgage payment at 29 years and six months. Where have you saved any interest expense?