How about doing both at the same time
Many financial writers will claim that everyone needs to build and emergency fund of some kind that is kept in a liquid vehicle such as a high interest savings account ( I prefer ING DIRECT ) a money-market fund, or some other readily accessible investment like a cashable certificate of deposit.
While I am a fan of financial leverage and will swear up and down for as long as I live that leverage is the ONLY way to build exponential wealth, I still believe in making extra payments on my mortgage versus having excessive funds in a savings account.
First off, I do have a savings account but it is hardly at the level of 6-12 months of living expenses. In fact, it consists of about 3 months of living expenses and possibly less from time to time. What I do have is a mortgage with an attached revolving interest-only line of credit.
The reason that I make extra payments on my mortgage (after funding all of my tax advantaged investment accounts) is that I reduce the amount of interest that I pay on the principal of the mortgage amount. My mortgage interest rate is currently at 4.25%, while my savings account interest rate is just over 3.0%.
Therefore, because all payments made against my mortgage simply increase the amount available to me through the line of credit, it is financially smarter to pay down the mortgage and borrow the money back for investing (When and if I find an appropriate investment) rather than pay the 4.25% interest on the mortgage and collect 3+% interest on my savings.
P.S – In Canada Interest paid on loans for investment purposes is tax deductible, while mortgage interest on a principal residence is not. Check with your personal tax advisor for an explanation of the advantages.
Psychology of Money
Of course there is the psychological factor of knowing you have cash in the bank in case of an emergency. However, there is also a psychological advantage to reducing your mortgage (or other debt – I only have mortgage debt left).
For most folks it is a good idea to have a “rainy day fund”. However, if you can mange credit wisely it may be in your best interest to set up an appropriate line of credit for emergencies. In addition, you will then also have the ability to pounce on investment opportunities that might come out of the blue.
Remember, strike a balance that is right for you and always due your due diligence!