I have come to somewhat of an epiphany/understanding of my monetary self over the past few weeks. Part of this revelation was due to some recent financial trouble that we have had. That trouble stemmed from unexpected expenses that caused me, for the first time, in over 18 months to carry forward a balance on the rewards credit card that I use.
In my past I have racked up credit card. Sometimes lots of it. I think right before I got serious about our financial situation I had racked up almost 35 k in credit card debt of some kind. And I paid that off in a fairly quick fashion, but I vowed never to go back to that place again. That is why when I accrued that credit card debt I constantly thought about ways to get rid of it.
So last week I made a decision. I decided to take $3700 from our emergency fund and pay off the credit card debt.
Then as I thought some more (and I have had this feeling for awhile) I realized I had my money not doing anything. The fact of the matter is that 10k was just sitting in the bank earning little to no interest. I need to do something with it. I need it to give me some kind of return through investments, paying down debt, etc.
Most likely that money will be used for two things: 1) to pay for a home repair that we are doing at the end of this week (more on this later); 2) to pay down some debt on the mortgage or car. Considering I said I wanted to pay off the car as quickly as possible this might be the best place to put it.
If I do this, however, I look like a hypocrite. I have advocated on this blog that you need an emergency fund. The most basic emergency fund should be the “four walls” emergency fund that includes money for food, utilities, housing, and basic clothing. So when/if I liquidate this fund I will basically have nothing saved except for maybe $1000 in cash that I will keep around. So what do we do then?
Using a HELOC as an Emergency Fund
The more I thought about this dilemma the more I decided to do some research into potential alternatives. I mean I could use a credit card as as emergency fund and just pay it off eventually, but the problem with that is that it could be too tempting to use for other things. But in a jam I could use it.
However, I wanted something that I could access, but I wouldn’t be tempted to use for just everyday expenses. And then as I sat down the epiphany hit me. I was sitting in my emergency fund. I was sitting in my house. Because of a nice home appreciation in our area plus we have paid down our mortgage balance I have enough of a cushion that I could tap our home equity if needed in case of an emergency through a HELOC (Home Equity Line of Credit).
What is a HELOC?
A HELOC and a home equity loan are NOT the same things. A HELOC is basically where you apply to your bank or to another bank and you ask for a line of credit based upon your mortgage balance vs. the value of the house. For example, let’s say you have a $200,000 house and you owe $140,000 on your mortgage you most likely can obtain a HELOC of about $20,000. Typically, you can’t obtain a HELOC that is more than 80% of a loan to value ratio (LTV) of your home). With a HELOC you will often receive a checking account and potentially a debit card that you could use for potentially emergencies. It is like using a bank account.
However, you don’t use it like a bank account for everyday expenses. In the case of an emergency you only use it for EMERGENCIES. A vacation expense is not an emergency. A new car is NOT an emergency. Your house blowing up….that is an emergency.
That is the key with a HELOC as an emergency fund. You should only use it in a true emergency.
The HELOC is basically a line of credit that you can draw upon when you need it. You don’t have to use it.
How to Obtain a HELOC?
Obtaining a HELOC is a fairly simple process. First, you have know what your home is worth so you might have to pay for an appraisal, which could cost you a couple hundred dollars. Then you have to have enough a low enough loan to value ratio to obtain a HELOC. That is determined by how much you owe on the house vs. how much it is worth.
You can apply to different banks to obtain a HELOC and you do NOT have to use your own bank for one.
Once you are approved for a HELOC there is often a small fee to open one and then typically a maintenance fee to keep it open, which is often $50-$75. Consider this to be like an annual fee on a credit card.
Once you have obtained it you can use it in case you have an emergency.
The Advantages of a HELOC
There are some advantages to a HELOC compared to other emergency fund alternatives.
First, you obtain the HELOC fairly quickly. It is not quite as onerous process as obtaining a mortgage and can be done within a few days/a couple of weeks. It is really dependent on your home value and how much you have paid down the mortgage.
Second, you don’t have to wait to save up for an emergency fund. Trying to save $10-20k for an emergency fund can be a fairly daunting task if you think about it. Depending on how much money you are clearing each month it could take almost a year or two to save for your emergency fund. Whereas, when you pay your mortgage you are engaging in forced savings. So you are already creating a potential emergency cushion even while you are paying off other debts as well.
Third, you can deduct the interest you pay on a HELOC like mortgage interest. Of course, the reason you do this is because you have used your HELOC. You don’t want to use it, in my opinion, for anything other than emergency. If you want to fix up your house get a home equity loan, not a HELOC.
The Downside of a HELOC
Like everything there are potential costs to a HELOC.
First, you will be charged interest on it if you use it. For example, my bank offers a .99% interest rate for the first 12 months of the HELOC and then it goes up depending on the prevailing interest rates. So using a HELOC will cost your interest.
Second, the bank can take your HELOC away. During the financial crisis a number of banks simply rescinded the HELOCs of homeowners, which did not allow people to tap their equity in case of an emergency. That is always a risk with a HELOC because it can be taken away.
Third, there is the possibility of abuse. Because you have a line of credit sitting there, similar to a credit card, it could be really tempting to use just for normal everyday items. You have to have discipline when using this instrument. One of the reasons why I would want to use this as an emergency fund is that even though I could have quick access to it I wouldn’t use it for daily expenses so it would almost be out of sight out of mind.
Finally, you are using debt to fund an emergency. The whole point of having liquid cash in an emergency fund is so that you don’t go back into debt. When you use a HELOC you are going into debt. And for some people, particularly if you just got out of debt, can be a frightening task. That is why for some people having a cash cushion might be the better decision.
The Bottom Line
I know myself well enough that I hate having cash just laying around doing nothing. I need it to do something. I don’t like having a lot of money in the bank that isn’t invested in some way shape or form. I like getting a return on my money. That is why a HELOC as an emergnecy fund might be right for me.
I am not saying it is right for everyone. Each person’s situation is different. And if you don’t have a house then a HELOC isn’t an option. You should have some emergency savings around. Maybe that is in the form of a ROTH IRA or something that you could access fairly quickly, but is invested.
You need the ability to have access to liquidity quickly in case of an emergency no matter what. In my case, however, I like the idea of being fairly nimble and making all of my cash work for me in some way shape or form. But I have enough financial items at my disposal that I think I can take care of any emergency fairly quickly. The key to using this strategy is to NOT use it. Any emergency money should be used only for emergencies and nothing else, which requires discipline and patience. Unfortunately, sometimes those are qualities that I lack in my impatience to get out of debt and create greater security for my family.
What do you think about a HELOC as an emergency fund?