Using a HELOC as an Emergency Fund

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Establishing an emergency fund is one of the fundamental steps in building a firm financial foundation. Emergency funds provide you with a buffer for when, not if, but when life throws a curveball your way.

Traditionally, such funds are maintained in highly liquid assets, accessible at a moment’s notice to cover unforeseen expenses or to provide a financial buffer in times of income disruption. Most emergency funds consist of a checking, savings, or money market fund and perhaps some cash on hand that is easily accessible.

A question I often get is should you use equity in a home as an emergency fund using a Home Equity Line of Credit or HELOC. This article explores the consideration of using a HELOC in this capacity, including how it can be integrated with other emergency funds and the implications for traditional liquid savings.

What is a HELOC?

A HELOC is a revolving line of credit based on the equity in a homeowner’s property. It operates similarly to a credit card, offering a flexible borrowing limit that can be drawn upon as needed, with interest accruing only on the amount borrowed. Once a HELOC is established, using the HELOC is as simple as writing a check off the HELOC or using a card.

The appeal of a HELOC lies in its relatively low interest rates compared to unsecured credit options, along with the potential tax deductibility of interest payments if the funds are used to “buy, build, or substantially improve the taxpayer’s home” that secures the loan, as per the IRS guidelines.

A final key characteristic of HELOC’s is that they are “secured” loan which means they are backed by an asset – your home. Unsecured loans like credit cards are not backed by a specific asset. As the HELOC is secured by your home, you need to have equity in your home – what your home is worth minus what you might owe.

The Primary Objective of Using A HELOC for an Emergency Fund

Let’s assume you want to maintain a $60,000 emergency fund. The question at hand is how should you accomplish that?

Should you just have $60,000 sitting in cash at the bank? Or should you keep $20,000 at the bank and have a $40,000 HELOC. Since you are not being charged interest on an unused $40,000 HELOC, you can then allocate the $40,000 cash to perhaps more productive purposes (starting a business, buying rental properties, investing in higher yielding assets like CD’s or other investments, etc.).

The following example illustrates this strategy. In this scenario, reallocating $40,000 to a 1-year CD yielding 5% versus keeping in a bank account earning 1% can net an additional $1,600 per year!

When comparing being able to invest or earn more, a fair comparison using returns consistent with safer investments. For example, assuming an investment return consistent with CD’s where their principal is guaranteed rather than the average historic rate of return for stocks of around 10%. After all, if an emergency does pop up, a stock portfolio could be down as much as 50% resulting in a far worse outcome if you need to sell at that point.

The Key to Successfully Using a HELOC as an Emergency Fund

The goal of an emergency fund is to be able to cover those unforeseen expenses without incurring large costs. In order to accomplish that using a HELOC and the key to using this strategy successfully is that you need to have a plan to pay off the HELOC quickly.

How do you pay off a HELOC quickly? Either have a high monthly free cash flow, the ability to free up cash flow, or have a relatively stable asset that could be used to pay it off.

The following example illustrates what happens if you do incur a large emergency expense of $60,000. In a 100% cash emergency fund, you cover the full expense and lose out on the interest that you would have earned. In using a HELOC, you lose out on the interest on the $20,000 cash used, and incur interest charges on the HELOC. In the below example, holding the CD to term would offset the interest of the HELOC resulting in a loss of $1,600 of value effectively reversing the benefits. Of course, you could exit the CD early, potentially incurring an expense or losing out on accrued interest, to pay off the HELOC putting you in a similar situation as the Cash as Emergency.

Comparison of a Used Cash Emergency Fund vs a Used HELOC for Emergency

However, if you do not have liquidity available to pay down the HELOC and do carry a balance, the benefits of the strategy can quickly reverse and put you in a rapidly declining situation. In the below example, you utilize the $20,000 bank balance and add $40,000 to the HELOC but aren’t able to pay it off. Interest alone calculated on the HELOC ends up being $3,600 per year not to mention having to make payments to pay down the principal.

Comparison of Using Cash for Emergency vs HELOC without Supporting Asset

HELOC as an Emergency Fund

Advantages

Increased Liquidity: A HELOC provides immediate access to significant funds without liquidating investments or savings that may have withdrawal penalties or tax implications.
Lower Interest Rates than other Loans: By using a HELOC for emergencies, homeowners can avoid higher interest rates associated with credit cards or personal loans.
Flexibility: HELOC’s have more flexible repayment options than credit cards allowing longer repayment periods and even periods of non-repayment. While this can be advantageous in a pinch, any interest charges accrue to the balance and can cause the HELOC balance to grow.
Reduce Excessive Cash: Maintaining a HELOC can help you re-align excess cash to higher yielding options.

Risks

Puts Your Home at Risk: Since a HELOC is secured by your home, failure to repay can lead to foreclosure on your home. While this could happen if you utilize other unsecured debt
Increased Interest Charges: If
Variable Interest Rates: Most HELOCs have variable interest rates, which can increase borrowing costs unpredictably.
Earning Potential vs Interest Potential:
Potential for Overspending: The ease of access to a large credit line can lead to misuse, particularly if it’s tapped for non-emergencies.

Integrating a HELOC with Other Emergency Funds

A strategic approach to financial preparedness involves diversifying your emergency resources. A HELOC should not replace liquid savings entirely but rather complement them. Here’s how to integrate a HELOC with other emergency funds:

Maintain a Reduced Liquid Emergency Fund: With a HELOC in place, you might consider decreasing your liquid emergency fund. For instance, instead of the traditional six months’ worth of expenses in a savings account, you might reduce this to three months, knowing you have a HELOC as a backup.
Establish Guidelines for which funds to use first in an Emergency: Typically, liquid savings should be your first line of defense to avoid unnecessary debt. Reserve the HELOC for more significant emergencies or when your liquid fund is depleted.
Regularly Review Your Financial Plan: Assess your emergency fund strategy annually. This includes reviewing your HELOC terms, checking the interest rate, and ensuring that your liquid savings are adequate for your current financial situation.

Common Costs Associated with HELOCs

Before taking out a HELOC, or any loan for that matter, you should be familiar with the costs associated with the loan. For a HELOC, the following costs are common:

Closing Cost: Typically, you’ll pay closing costs to establish a HELOC. These costs can vary significantly lender to lender.
Annual Maintenance: The HELOC may also have an annual maintenance charge whether the HELOC is used or not.
Interest Charges: HELOC rates are variable and are typically tied to the PRIME rate plus a fixed rate. For example, Prime + 1% would mean if PRIME is 8% then the HELOC rate is 9%. If PRIME falls to 5% then the HELOC rate would fall to 6%.

Conclusion

A HELOC can be a valuable component of an emergency fund strategy, offering flexibility and access to funds at relatively low interest rates. However, it is crucial to balance this with the maintenance of some level of liquid savings to protect against the inherent risks of borrowing against home equity. By thoughtfully integrating a HELOC with other emergency funds, homeowners can achieve a more nuanced and resilient approach to financial emergencies, tailored to their unique circumstances and risk tolerance.