If you’re lucky, you go about life without facing too many events you’d call true emergencies. But even the most “glass half-full” adults understand the phrase hoping for the best has an important ending…preparing for the worst. For many people, that preparation involves saving at least 3-6 months of expenses in an emergency fund, maybe even more.
Many factors influence how much money people put in their emergency funds. Their level of debt, the stability of their job, the number and health of the people living in the household, and the amount and access to other funds to pay for emergencies may all come into play.
People want emergency funds because they allow a level of control over emergencies not in your control. And whether you are risk-averse or not, having money to pay for things in crisis matters. It allows you to focus on the emergency, not the money – and that’s priceless.
Where Do People Keep Emergency Funds?
Traditional advice suggests keeping emergency funds in a savings account so that you have fast access to cash. Many of those emergency funds are now held in online savings accounts offering higher interest rates than those a brick-and-mortar bank provides.
Others choose to use money market accounts for slightly higher rates or pick no penalty Certificates of Deposit (CD’s) or “ladder” CD’s so they have access to penalty-free funds maturing at different times.
A Roth IRA is another option people consider because you can withdraw the amount you contributed to it penalty-free if you face an emergency and need the money.
What About Using the Equity in My Home Instead?
Some people have trouble saving large sums of money. Others hate seeing their cash sitting in a savings account not invested or used to purchase other assets like rental properties.
But they may have equity in their home and would prefer to tap into it if an emergency happens.
Since a Home Equity Line of Credit or HELOC provides a homeowner with a revolving line of credit using the equity in their home, they are often used to pay for large expenses; home renovations or college tuition for kids, for example.
You’re given a certain limit, and you pay back whatever you borrow, with interest, similar to a credit card. If you don’t use the money, you don’t pay anything.
That’s what many people think about when they consider using a HELOC as their emergency fund. They will still have access to a sum of cash to help them survive a financial emergency, but they don’t have to use it. They also won’t have money just sitting in an account waiting for a bad thing to happen.
But there’s definitely a difference between an emergency fund and a HELOC. One is using a surplus of money, and the other requires taking on debt.
Does that mean taking a HELOC as your emergency fund is never a good idea?
Never isn’t a word we use much in personal finance. That’s because so many things depend on your specific situation.
Let’s consider the benefits and the drawbacks to determine who a HELOC might work for and who should keep setting aside cash to fund future emergencies instead.
Benefits of Using a HELOC As an Emergency Fund
It’s important to understand the advantages of using a HELOC as an emergency fund to determine if the strategy is a smart move for you.
You can quickly access a large sum of money.
HELOC’s limits are generally set at 80-85% of the home’s appraisal value, minus the amount of any mortgage on the home. If a house appraises for $250,000 and the existing mortgage is $150,000, the owner can likely apply for a line of credit of at least 80% of $100,000 they have in equity – or $80,000.
If monthly expenses are $5,000, the HELOC will provide far more than the 3-6 months of living expenses someone may have saved in an emergency fund.
The money you’d put in an emergency fund can be invested for the future.
If you were to save 3-6 months of expenses (at $5,000/month) for your emergency fund, you’d have between $15,000 – $30,000 in an account. While it could be earning some interest, you may be looking for much higher returns than you’ll see in typical accounts used for emergency funds.
Your emergency funds could be more aggressively invested to earn higher returns possibly. You could also use those funds for the down payment on a rental property if that’s in your wealth-building plan.
You may never need to access the HELOC.
The need to access a HELOC can depend on the type of crisis you face when the emergency happens, and the extra expenses you’ll have in dealing with the situation.
If you’re working, you may be able to cash flow critical events without tapping your HELOC. And even if you do use it, you might be able to pay off quickly what you borrowed without paying much interest.
Looking at these advantages, having access to a HELOC and skipping an emergency fund might make sense. But you’ll want to read on and consider the negatives about HELOC’s too.
Drawbacks of Using a HELOC as an Emergency Fund
There are some things you need to consider if you are thinking about using the equity in your home as an emergency fund.
There are usually fees and closing costs for taking out a HELOC.
You might consider the equity you have in your home as your money, but accessing that money will likely cost you. You’ll likely pay for an appraisal of your home, along with origination and annual fees for the line of credit. Depending on where you live, there may be more required closing costs to pay too.
Understanding the terms of the HELOC is essential. The line of credit you are offered, and the interest rate you pay may depend on your income, credit score, and credit history, among other factors.
You might feel the temptation to use the money for things that aren’t emergencies.
Spending money from an emergency fund reduces what you’ve saved but spending money from a HELOC adds to your debt.
Unless you can be sure you won’t take a vacation, buy all new furniture, or start remodeling projects with your HELOC – don’t use a HELOC as an emergency fund.
The collateral for the line of credit is the roof over your head.
If you’re using a HELOC as an emergency fund and you do have a crisis, you still have to be able to pay what you borrow. Should the emergency involve you or another person who contributes to your household income, will you be able to pay all of your bills and make payments on the HELOC?
If you can access other funds during an expensive medical event or long-term situation where you can’t work, it might not be a problem. But don’t underestimate the financial stress you could be under trying to make payments on a HELOC in addition to all of your other bills.
Knowing your house could face a foreclosure may have you re-thinking whether putting money into an emergency fund is a better option in your situation.
Variable interest rates and the possibility of the HELOC being reduced or canceled.
Most HELOC’s have variable interest rates that can change from month to month. This wasn’t a big concern for many years, but with interest rates on the rise and the recent loss of some tax benefits, it’s another thing to think about when planning to use a HELOC as an emergency fund.
Even though it doesn’t happen often, banks can also reduce or cancel HELOC’s. If your house value falls significantly or if there is a financial crisis like a recession, you may have more than one emergency on your hand.
The equity in your house may drop, and you may face another financial stress like a job loss. What happens if you have an emergency event like a medical crisis on top of everything? This may make it very difficult to access your HELOC or make payments on money you’ve borrowed on it.
Is it Smart to Use a HELOC as an Emergency Fund?
Only you can decide whether using a HELOC as an emergency fund makes sense for your situation. There are some definite benefits from putting your money to work to grow your wealth, but there are definitely some risks to consider.
If you do decide to use a HELOC for emergencies, you may still want to save some cash to avoid using the HELOC for smaller issues. Or you need the cash to help make payments on the HELOC if you do borrow money.
You should also decide ahead of time what constitutes an emergency and when you would use your line of credit. If you have a partner, discuss the pros and cons of saving an emergency fund vs. taking out a HELOC. Make sure you are on the same page with the decisions you make.
Some people have strong feelings about taking on debt when you can save for an emergency. If you’ve educated yourself and understand the terms of the HELOC and are willing to accept the risks associated with using it for a financial emergency, a HELOC may make sense for you.