Can I Use My HELOC as an Emergency Fund?
There are lots of things that could potentially derail you financially: you could get laid off from your job, you could have surprise medical bills, a natural disaster could damage your home. Planning for an emergency is next to impossible, but that doesn't mean you can't be prepared for one.
That's where having an emergency fund comes in.
How much should I have
Most experts recommend that your emergency fund covers six months of expenses for you and your family. We're not talking about things you can easily cut out of your budget like eating out or going on vacation, just the things you really can't live without. Write down how much you spend each month on these expenses:
- mortgage payment
- any other debt payments (credit cards, student loans, etc)
- utilities
- phone and internet
- insurance (home, health, car)
- transportation (car payments, gas, bus fare)
- grocery bills
- childcare expenses
Add all those expenses up and multiply times six. That's how much you should have in your emergency fund.
Can I use a HELOC as an emergency fund?
A lot of people who don't have an emergency fund end up having to rely on credit cards if an emergency does come up. That's a problem because credit cards have high-interest rates and we all know how difficult it can be to dig yourself out of that kind of debt.
So, can opening a Home Equity Line of Credit (HELOC) before you need it be your version of an emergency fund?
First, you need to understand how a HELOC works. It's a little different from a loan in that you don't need to use all the money at once and then start paying it back. Instead, it actually works a lot like a credit card except instead of borrowing money from a bank, you're borrowing money from the equity in your home. Like a credit card, your HELOC will have a limit to how much you can borrow before you start paying back. So, if your HELOC has a $20,000 limit, that means you can borrow up to that amount.
The limit is something that makes a HELOC a little different than a loan, too. With a loan, you can only get the set amount of money your lender decides. But with a HELOC, you can borrow again and again as long as you keep paying back. So if you borrow $10,000, then you can only borrow $10,000 to meet your $20,000 limit. But if you pay back $5,000 then you have $15,000 available to you.
The big difference between a HELOC and a credit card is that your interest rate on your HELOC is going to be a lot lower than your credit card, which is one thing that makes it a lot more desirable than a credit card.
Is it big enough
If you just bought your home, you probably don't have any more equity in it than what you used as a down payment. For more affordable homes, that might not be enough to cover six months of expenses. If that's the case for you, just make sure you're supplementing your HELOC with a more traditional emergency fund so that all your bases are covered.
Willpower
Once you open a HELOC, you suddenly have access to a big line of credit that you could use for just about anything. Want to redo the basement? There's money for that. Thinking about proposing? You have the means to buy a pretty fancy ring. If you know that you're the type of person who's going to be too tempted by that line of credit to just keep it for emergencies, then having a HELOC open isn't the greatest idea. Remember, you will need to pay back whatever you spend, plus interest. So, spending it unnecessarily is going to end up costing you in the long run.
Interest rates
Speaking of paying back with interest, remember that you'll need to take those rates into account when and if you do need to spend the money. Tacking on extra to your already big bill might not be the best feeling in the world when you're already trying to dig yourself out of your financial setback.
You might lose out on investing
This is a tricky one. On one hand, if you had a big chunk of money in an interest-earning account, you would be making money from your emergency fund. The downside is that you need to make sure that money is in a fairly liquid account, meaning you can withdraw it whenever you want without a penalty. But, if you're using a HELOC as your emergency fund then you could potentially be freeing up money for more high-yield investments, like the stock market. If investing is a main motivation for you, it's a good idea to talk to a financial advisor to get a better sense of what makes the most sense for you and your lifestyle.
Your lender can cancel or reduce your HELOC
Unlike a loan, your lender can decide to cancel your HELOC or reduce the amount you're able to access. That's usually a response to other financial pressures on the bank That happened to a lot of people during the financial crisis of 2008—just when people were most in need of emergency funds.
No one wants to think about the worst-case scenario, but having an emergency fund can make all the difference when it comes to staying afloat in bad times.