How To Use a HELOC as an Emergency Fund
Most people have heard of a cash emergency fund even if they don't have one: six months of expenses earmarked for a financial setback.
But can a home equity line of credit, or HELOC, serve this purpose?
It certainly would be quicker than saving up thousands of dollars.
A HELOC can do the job, but is probably a better backup strategy than your primary emergency fund solution. Here are things to consider.
Speak with a lender about your HELOC eligibility.
How an Emergency HELOC Works
An emergency HELOC is when you open a home equity line but leave it at zero balance until you need funds.
If you lose your job or experience another financial hit, you don't have to get approved for a loan: the funds are available.
This is an affordable strategy. You don’t pay interest until you draw out funds (though there may be an annual fee). Many HELOCs come with a 10-year period where you can draw and pay back funds as needed.
You might have a $100,000 available limit but no balance; it costs nothing until you draw funds.
It’s a fantastic rainy day fund.
For example, your expenses are $5,000 per month. A $60,000 credit line could get you through a 12-month job loss. You only need to draw what you need each month, minimizing interest costs.
Emergency HELOC Pros
You get approved for the loan while you can qualify. You don’t have to prove income or credit when you need the funds.
HELOC interest rates are one-half to one-third those of credit cards. You don’t pay exorbitant interest costs when you can least afford them.
A HELOC may allow you to access more funds than credit cards or personal loans. Limits can be $100,000 or more.
You don’t pay interest on funds until you borrow
While this strategy has many advantages, it's not without risk.
Cons: Why a HELOC Shouldn’t Be Your Only Emergency Fund
There are a few reasons that a HELOC doesn’t work well as your primary source of emergency funds.
1. Your Lender Can Freeze Your HELOC
HELOC lenders have the legal right to stop you from drawing funds. This is called a HELOC freeze. Falling home values, lower credit, a job loss, or failure to make a HELOC payment can trigger this action.
Your HELOC may not be available when you need it most.
However, the lender may not lower your credit limit below what’s owed. So one strategy could be to pull out the entire HELOC at the first sign of trouble – such as the day you’re laid off.
But this leaves a lot to chance. The lender may have already restricted borrowing by the time you need it.
2. You Pay Interest On Borrowed Funds, Digging a Deeper Hole
The expression “when you’re in a hole, stop digging” might apply here.
At 8%, for example, a $50,000 HELOC balance would cost $333 per month, assuming you pay interest only (common for HELOCs).
You could pay it by pulling more out of your HELOC, but you can imagine where that leads.
3. Your House is On the Line
A HELOC is a second mortgage. The lender can foreclose on the home if you don’t pay – even if you’re keeping up on your primary mortgage payments.
4. You Could Max Out the HELOC
Like credit cards, HELOCs come with borrowing limits. The lender is not likely to increase the limit when you most need it. You risk borrowing the full limit and having no more access to funds.
A Layered Emergency Fund Strategy
It’s a good idea to open up a HELOC for emergency purposes as soon as possible. But it should only be part of a layered emergency fund strategy.
Following are additional “layers.”
Savings: A liquid savings account with six months of expenses should be your primary emergency fund. It’s okay if this is a high-yield savings account as long as there are little or no penalties for withdrawal.
401k loan: You can borrow against your 401k without tax penalty for financial hardship. You pay yourself back with interest, which is better than paying interest to your lender. Speak to a licensed tax professional before making such a move, though.
Investments: In a pinch, you can sell stocks, bonds, and ETFs to keep afloat. You may have to sell at a loss, forfeit future gains, or pay capital gains tax.
HELOC: As discussed, a home equity line should be part of your emergency strategy.
Personal line of credit: A personal line of credit is like a HELOC in that you can draw funds as needed. It is not tied to your house, lowering the risk of foreclosure. However, interest rates are higher than for HELOCs.
See If You Qualify for a HELOC
Don’t wait until you need an emergency HELOC. At that point, you won’t qualify for one.
Prepare now by applying for a HELOC and closing as soon as possible. That way, t’s ready in case you need it.
Tim Lucas is the editor and Lead Analyst for MortgageResearch.com. Tim spent 11 years in the mortgage industry and now leverages that real-world knowledge to give consumers reliable, actionable advice. He has been featured in national publications such as Time, U.S. News, MSN, The Mortgage Reports, and more.
