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Forced Savings — How Your Monthly Payments Build Equity

I’ve encountered the term “forced savings” or “forced saving” for years without giving it a second thought. It was one of those financial buzzwords that went in one ear and out the other. 

This changed recently when I realized that forced saving is literally all around us. Approximately 66% of Americans own their homes and roughly 63% of those homeowners have mortgages. Because it builds equity that can be converted to cash when the home is sold or mortgaged again, the principal portion of each and every monthly mortgage payment is a form of forced savings. 

So if you’re still paying off your mortgage, you’re forced to save each month. And if your mortgage is already paid off — congratulations! — then you have a tidy nest egg courtesy of years of forced saving. You might have other, hidden examples of this financial phenomenon in your life too.

What Is Forced Savings?

Forced saving happens whenever you make payments that build equity over time. 

Equity is a fancy word for “an asset’s potential cash value.” You can’t spend equity at the grocery store, but you can access it by borrowing against it or selling the underlying asset.

A common example of equity is home equity, which is the difference between your home’s market value and the amount you still owe on the mortgage. You access your home equity by selling your house or borrowing against it with a home equity loan or line of credit. Otherwise, its contribution to your net worth remains theoretical.

Other financial products build equity too, including cash value life insurance and credit-builder loans. These products build equity at varying rates. The fact that they build equity at all is often secondary to their primary purpose, like replacing income you won’t earn because you’re dead or raising your credit score.

Examples of Forced Savings

The most common instance of forced savings — at least as we’re discussing it here — is home equity built through mortgage payments. 

Other reasonably common examples include cash value life insurance (whole life insurance and its variations) and secured loans that return some or all of your principal payments when paid off. 

Mortgage Payments (Building Home Equity)

If you don’t have enough cash to comfortably cover the entire cost of buying a home, you need a mortgage. The initial amount of your mortgage loan is the purchase price of the house, plus closing costs, minus the down payment.

A Down Payment on Forced Savings

You can think of the down payment as your initial equity. It probably comes out of your savings account, so if you think of your home equity as “potential cash,” your down payment merely moves cash from one highly accessible place to another, not so accessible one.

In a simple world where you buy your house for its exact fair market value, your initial equity is equal to your down payment. So if you put down 20% of the home’s purchase price, your initial equity is 20%. Were you to (inexplicably) sell your house before making a single mortgage payment, you’d get that 20% back as cash, less closing costs.

How Forced Savings Works for Real Homeowners

Time for some real numbers. 

You buy a house for $400,000 and put down $80,000, or 20%. You finance the remaining $320,000 with a 30-year fixed-rate mortgage at 6.7% APR. That’s a realistic interest rate at the time of this writing, by the way, but your actual rate would vary based on your credit score, income, and prevailing market rates at the time, among other factors.

To pay off this mortgage, you must make 360 equal monthly payments of $2,064.89. The interest portion of each payment goes directly into the lender’s pocket. The principal portion reduces the remaining balance on the loan. If you sell your home before paying off the entire loan, the lender receives the remaining balance and you get whatever is left over — your equity — in cash.

In other words, the longer you pay on the loan, the more you’re forced to save. And in fact, because of the way lenders charge interest, the principal portion gets a tiny bit larger with every payment. You’re forced to save a little more, proportionally speaking, each month.

Your purchase price, down payment, interest rate, and loan term determine the precise interplay between interest and forced savings (principal) payments over time. This is what the first 12 payments look like for a $320,000, 30-year fixed mortgage at 6.7% APR:

MonthPrincipalInterestTotal Forced Saving

So your first monthly payment forces you to save $278.22. Your 12th monthly payment forces you to save $295.80, or $17.58 more than the first. Over the entire period, you’re forced to save $3,443.14.

Fast forward 28 years. You’re older, grayer, and still paying off your mortgage — but you’re almost done! Here’s what those final 12 payments look like:

MonthPrincipalInterestTotal Forced Saving

As you can see, your forced savings rate accelerates dramatically over time. Your final 12 payments are almost entirely forced savings — $23,902.36 over the course of the year. That’s seven times as much as you saved during the first year.

Other Examples of Forced Savings

If you encounter one type of forced savings in your life, it’s likely to be a mortgage loan. But there are three other examples worth a brief mention: 

  • Cash Value Life Insurance Policies. All cash value policies have a forced savings component that’s sort of like home equity. You can borrow against it, withdraw it, or access it all by surrendering the policy — essentially, selling it back to the insurance company. As with a mortgage, your forced savings rate increases over time. 
  • Credit-Builder Loans. A credit-builder loan is a secured credit card alternative for people with bad or limited credit. The lender sets up a locked savings account in the amount of the loan. The principal portion of each monthly payment is forced savings — literally, it unlocks a portion of the secured cash. After your last payment, the entire loan amount is yours.
  • Auto Loans. It’s controversial to think of auto loan payments as forced savings because unlike a house, a car is a depreciating asset whose value eventually goes to zero. But many drivers sell or trade in their cars while they’re still worth something, recapturing a portion of their forced savings (principal) payments.

Alternative Definition: Forced Savings Due to Economic Conditions

Mortgages, credit-builder loans, cash value life insurance. These are all examples of financial products that indirectly help you save — or more accurately, grow your net worth — by accumulating equity that you can later turn into cash.

This phenomenon is what most people mean when they talk about forced savings. But it’s not the only way to define the term.

There’s also what I call the “economics definition” of forced savings. It’s an extreme-sounding scenario where you’re forced to spend less than you earn due to some combination of:

  • Goods shortages that prevent you from buying what you want or need
  • Hyperinflation that renders basic goods or services too expensive for you to buy
  • A breakdown in credit markets, such that you can’t buy stuff on credit even if you can afford to pay off those purchases or can’t find credit at reasonable interest rates

The result is that you have more cash on hand than expected at the end of the month or year or whatever time horizon you’re measuring on. That sounds like a good thing, but remember that it tends to occur alongside runaway inflation, where paychecks can’t keep up with price increases. So whatever money you’re “forced” to save is worth less and less over time.

Unfortunately, there are plenty of recent real-world examples of forced savings due to economic conditions. It’s more likely to occur in closed economies, where goods shortages are common and credit markets don’t function well, and wherever inflation gets deeply entrenched.

Final Word

If you have a mortgage, the principal portion of your monthly payment builds equity — potential cash — in your home. This is forced savings.

Forced savings sounds like a good deal, and it is as far as it goes. Your forced savings balance is there if you need to borrow against it. You’ll see it again if and when you sell your house. It’s an important foundation for longer-term wealth.

But forced savings is no substitute for a robust emergency savings fund capable of covering several months’ expenses should you become unable to work or otherwise fall on hard times. Your emergency savings needs to be liquid, ideally earning a decent return in a high-yield savings account. And you need to hold yourself accountable for growing and maintaining the balance.

That sounds suspiciously like forced savings to me. But look on the bright side. Unlike your monthly mortgage payment, 100% of every single “forced” emergency savings deposit goes right back in your pocket.

Brian Martucci writes about credit cards, banking, insurance, travel, and more. When he's not investigating time- and money-saving strategies for Money Crashers readers, you can find him exploring his favorite trails or sampling a new cuisine. Reach him on Twitter @Brian_Martucci.