Addressing risk by increasing liquidity

February 10th, 2009 · 2 Comments

We’ve decided to stop making extra principal payments on our loans.  Instead we’re going to direct that money into our GI portfolio to increase our liquidity.  Here is our reasoning.

image: http://www.sxc.hu/profile/tdnb

image: http://www.sxc.hu/profile/tdnb

This decision comes from a worry about suddenly losing our income when we’re in a situation of being house-rich but cash-poor.  The lenders don’t give you any credit at all for being ahead on your amortization schedule, they just insist on that minimum monthly payment rolling in like clockwork.  So even if we’ve paid off half the loan balance in 5 years instead of the 15 it should have taken, they’d still foreclose on us if we missed 3 monthly payments.  (Not that we’re quite that far ahead, I’m just illustrating a point.)  So we’re going to stop sending them extra money each month and instead keep those funds in something more liquid than real estate.

We view this as an overall risk reduction strategy as we’ll have more cash to cope with any surprises life might throw at us, whether they are of financial (job loss), medical (major illness), natural (storm disaster), or even something else in origin.  Yes, we have an emergency fund — which we really treat as more of an income replacement fund — but we both believe the current economic climate (multi-year depression?) has increased the risks we face and the only thing we could think of to do in response was to lengthen the runway of cash we’d have before we’d be in trouble.  In the event nothing calamitous happens, we can always use the funds we’ve built up to repay our loans with large single payments. In fact, if you do a bit of PF reading you’ll find a large group of people making well reasoned arguments that investing the cash yourself means paying off your mortgage earlier and with less overall risk.  We’ll leave the “proof” of that to another discussion for now, just accept that we’re thinking having more liquidity is a good thing right now.

Yes, this means we’re effectively forgoing a guaranteed return on the money that is equivalent to the interest rate on our loans, with a plus or minus for tax issues.  But we both felt that we could come close enough, or possibly even exceed, that return by using it in our GI portfolio that we’re willing to make the change.  In short, our response to overall increased financial risk is to hoard cash even if that increases return risk on that cash.

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Tags: Loans · Personal Finance

2 responses so far ↓

  1. 1 Brandon // 2009.02.10 at 10:57 am

    I’ve often thought about the same thing while prepaying principle on our mortgage. My thought was always that should catastrophe strike, I could liquefy the additional equity in my home through a refinance or HELOC and use that money to avert foreclosure. This strategy makes the assumption that additional principle payments actually constitute positive equity and not just a reduction in negative equity (i.e., I’m not upside down on my mortgage) *and* that should catastrophe strike, the bank will let me refinance anyway. Perhaps the prudent approach is to secure the line of credit before any adverse personal event strikes, leaving it untapped for that eventuality.

    You say, “In the event nothing calamitous happens, we can always use the funds we’ve built up to repay our loans with large single payments.” This begs the question, how do you know when “nothing calamitous happens”? In other words, what criteria are you using to determine the risk of “calamity” is low enough to start making accelerated principle payments (either incremental or lump sum) again?

  2. 2 davmp // 2009.02.10 at 1:47 pm

    @Brandon: I think many people followed that thought pattern and recently discovered that they can’t take out a HELOC or refinance when they needed it most. I’ve heard many banks had been freezing existing HELOCs as well, so even if you had secured that line of credit previously, it does no good unless you’d actually taken the money out prior to it being frozen. The fact is that we hadn’t secured either option so must do something different.

    Regarding the time frame for “nothing calamitous happens”, I’d say that there are some obviously objective measures such as having enough cash or easily liquidated investments to completely pay-off the loans. Or perhaps, having multiple years of income-replacement-savings in place. And then there is the ability to measure how well we’re actually doing — are we earning more than the equivalent return if we had paid down the loans? If not, perhaps we go back to pre-paying. All that being said though, the key driver for our discussions and decision was more the general unease with the state of the economy. There’s no objective measure to point to that counters that, we’ll just have to wait until we feel better about things.

    On another avenue of thought, we are considering this as a reasonable time to gauge our ability to exceed the return we get by pre-paying. If it goes very well in this environment, then we’d likely never go back to pre-paying the loans as we’d be better off to invest all available cash ourselves. If we do reasonably well, meaning we are keeping even with the return we’d get from pre-paying, then we’ll likely go back once we feel better about the balance of cash-on-hand vs. risks. And if it goes poorly, which is quite possible, then we’ll try to root-cause why and if we can’t “fix it”, go back to pre-paying.

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