A reader named Brian asks whether it’s a sound move to use a home equity line of credit as an emergency fund:
I enjoy your podcast, and I have great respect for your approach to personal finance. The 31-Day Money Challenge actually had me looking forward to my daily commute.
I have a simple question regarding an emergency fund. We currently have a net worth of about $400,000, which is a net of my mortgage of $190,000 and a car loan of $15,000. We maintain an emergency fund of $10,000 earning .85% in a savings account. I am considering opening a HELOC (Home Equity Line of Credit) of $30,000 at 6.8%.
I do not intend to draw on it unless there is a true emergency, so I expect my total cost to be only the $50 origination fee. With this Home Equity Line of Credit in place, I would use the $10,000 emergency fund to pay down the car loan.
Now, I know the conventional wisdom of 3 to 6 months. I am the sole breadwinner of a family of four, so I technically should have at least 6 months' worth of savings. However, I do not understand the logic.
I am a CPA, with a good job with a good company. I do not believe it would be difficult to quickly locate another equivalent position if I were to lose my job. We currently have a 30% savings rate and about $75,000 taxable investments we could access if absolutely necessary.
Question: Do you think it would be a poor decision to utilize the Home Equity Line of Credit in place of my current $10,000 emergency fund? If so, why? I appreciate any insight you are willing to provide.
Well, that is a fantastic question. What Brian is proposing does buck the trend. It's not the traditional advice, which is to keep your emergency fund cash in a savings account like he's doing now.
At .85%, he probably has his money in an online savings account - probably something like Capital One 360 or Ally.
To address Brian's question, we need to answer two questions, the one he asked and one he didn't ask. Let's start with the question he didn't ask.
Sell the car and buy a less expensive vehicle
The first thing to consider would be whether he should sell the car and buy a car that's a lot less expensive. Assuming that he could sell the car for what he owes, he could then take half of his existing emergency fund and buy a used car. He would wipe out all of his debt and still have $5,000 in his emergency fund.
There may be reasons why this approach is not ideal. He may need his vehicle for work. He may owe significantly more than the car is worth. But selling the car should be the first consideration.
Is a HELOC a good idea
Now to Brian’s question. Using a HELOC as an emergency fund is exactly what my wife and I did when we were climbing out of debt.
I think there are some things to consider before making that decision, though. I don’t have these hard and fast rules. If you’ve listened to my podcasts or read my blog much, you know that I think there’s a reason the word “personal” is in personal finance. It’s not a one size fits all.
Brian's email leads me to believe that his suggested approach may be a good one for his family. But when thinking about this approach, here are five things to consider:
1. What will you do with the money?
If you're going to spend your emergency fund down and then rely on a HELOC, what are you going to do with that money? Whether you're pulling it out of a savings account or simply not building an emergency fund, where is that money going?
In Brian's case, it's a car loan. That is, I think, an excellent place to put the money. It does raise some questions about what you'll do when you need your next car, though. Are you saving for the next vehicle so you can pay cash? Did you spend too much money on your current car?
Basically, are you going to do smart things with that money, or are you going to do dumb things with it? You'll know the difference. This is the first thing to consider.
2. Will you save the HELOC for a real emergency?
Are you disciplined enough to not use the line of credit except for a true emergency? A cruise is not an emergency. The fancy shoe sale at Macy's is not an emergency. Dinner out with friends is not an emergency.
You really need to be honest with yourself. Brian's approach is a non-starter if you end up going into debt by using the line of credit to buy things that aren't emergencies.
In my family’s case, this worked well for us. We did not use the line of credit for anything other than a backup emergency fund. And in our case, we didn’t even need it.
But will you really have the discipline to leave the line of credit alone? If not, this is not a good idea for you.
3. How secure is your job?
This is a point Brian made in his email. He's absolutely right to consider job stability.
How at risk is your job? And if you were to lose your job, are you in an industry or location where you can easily get a job with a comparable salary?
Brian mentioned that he's a CPA with a good company. I think CPAs are in demand, but, that depends on where he's located. He seems to think that he can find another job without much difficulty, and that seems right to me.
On the other hand, if you're in a manufacturing job in the Midwest where I grew up, you may be working with the only company in town. That's something you need to consider when assessing the amount and type of emergency fund that's right for you.
If your job is secure and you could easily find another one, a HELOC may not be bad as an emergency fund. Otherwise, you may want to consider having cash on hand.
4. What are the costs?
One of the terms of this Home Equity Line of Credit Brian mentions is the 6.8% APR and the $50 origination fee. Usually, there's also an annual fee. He didn't mention that, and maybe there is none for the loan he's considering. You want to consider all these costs.
When we had our HELOC, it was $75 per year in an annual fee, which isn’t a lot. But you definitely want to know the terms of the HELOC, and that’s going to depend in part on your credit score, income, credit history, loan-to-value ratio, and other factors.
I haven’t shopped for a HELOC in a while, but 6.8% sounds fairly reasonable to me. This is, of course, a secondary mortgage on your home. They’re generally going to be at a higher interest rate than a primary mortgage. So 6.8% seems reasonable, but you want to double-check that the terms are competitive and reasonable.
5. You may lose it
This is a warning, and it's so important to understand: Lines of credit can go away.
The bank can cancel your line of credit or reduce the amount of your available credit. That doesn't happen frequently. But when we hit that 2008-2009 crisis, I read a lot of stories of people losing some or all of their HELOC.
In some cases, homeowners had a balance on their home equity line of credit. Every single month when they paid a little bit of it down, their credit limit shrank to match their balance. So they could no longer use the HELOC for any purpose, including for emergencies.
This is something to consider. Again, it doesn't happen every day. But when that type of financial crisis occurs, a lot of bad things tend to happen at the same time.
6. Look for a HELOC in the right place
Shopping around for a HELOC can be a pain. Especially if you have to go into a bank, fill out paperwork, get approved for a loan (hopefully), hope to get a good rate, and wait for your funds.
Hometap is a new way to tap into your home’s equity. With this service, you’re able to access your home’s equity without taking on a monthly payment.
Rather than require a monthly loan payment, Hometap provides cash today in exchange for a share of your home’s future value. So, not only can you access your home’s equity without debt, but you have the opportunity to settle it any time within 10 years.
Hometap is a service worth considering if you want access to your home’s equity but are unsure if you can afford another monthly debt payment.
When you look at the entire picture - Brian's got a good job in a good field, plenty of taxable investments, and a savings rate of 30% - a HELOC may be a reasonable move for him.
The key, though, is that this isn’t a risk-free move. You need to make these kinds of decisions with your eyes wide open. Look at all the factors before jumping into a personal finance decision like this one.