Investment Strategies: Would You Invest Your Emergency Fund In Closing A Loan?

by Vinaya HS on September 23, 2010

in Finance

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S asks,

Suppose you have a loan that you desperately want to close. Is it worth dipping into your emergency fund for this purpose?

I can find convincing arguments on both sides. If you take this step, you get an immediate return on your investment (equal to the interest rate on the loan) but you expose yourself to the terrible risk of a cash crunch. And if you don’t, you’re safe in the short-term but you end up paying a whole lot of interest to the bank.

What should one do?

My advise is quite simple:

Closing a loan is never an emergency and should never be done at the cost of dipping into your emergency fund. The safest way to close a loan lies in utilizing your free cash flow. If your loan allows penalty-free prepayments against the principal, then use whatever free cash flow you have at the end of each month towards prepayment. Else accumulate your free cash flow until you can make a significant dent. This way you achieve your objective — albeit slower — without putting yourself into undue risk.

What do you think?

In fact, I’ve actually been in this situation recently. When I got very very close to closing the loan on my Swift, there was this strong inner voice that kept urging me to dip into my emergency fund and bridge the gap. Instead, I stuck by my rules, cut my spending further, increased my free cash flow, and finally closed the loan. It works!

You might also find this worth a read: Pay Cash or Not? Cash Flow Versus Liquidity.




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