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Investing Tip of the Day

* Use a portion of your emergency fund to pay ahead on interest-bearing bills

It’s usually a good idea to set aside 3-6 months of income for unexpected expenses. It makes it easier to stick to a financial plan and saves you from having to make an unwise move to cover the unexpected expense, such as liquidating stocks, tapping your 401k, or adding charges to a credit card. Most financial advisors will tell you to put it in a low-risk, easily-accessible account, such as a money market savings. I think that’s smart for some of your emergency fund, since it could be something like a sudden car or home repair needed where payment can’t wait. However, there are plenty of sudden expenses that don’t hit you immediately, most notably a job loss. If you lose your paycheck, you have to keep paying monthly bills while you look for a new job.

Here’s where the tip comes in: if you have loan payments due each month, you save interest from accruing if you pay ahead. For example, say you have a $1000 car payment that charges 8 percent interest. If you pay one month ahead, you save $6.66 per month in interest charges, or $80 for the year. Compare that to a typical bank savings account which pays practically nothing. The interest saved is actually more than $80 due to the effects of compounding. If you stay several months ahead in bills for mortgage and car payments, the effect can be quite substantial. And unlike an investment, there’s no risk–it’s a guaranteed return of the interest saved.

If you actually do lose your job, you need less money to cover your monthly bills since you’ve paid ahead. Simply wait and resume paying your bills around the due date for however many months you paid ahead. Even with something like a medical bill, you normally have some time to pay since the insurance process has to play out.

The interest savings of paying ahead will eventually have another pleasant benefit–paying off the loan early!

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