Going through a financial emergency is not a matter of “if” but “when.” This is a situation that all of us will go through – that is for sure. This is not about being pessimistic. The reality is that our lives can be greatly affected by factors that are beyond our control. No matter how careful we are, we can still be involved in a car accident – especially when we are unfortunate enough to drive alongside an irresponsible driver. This is the reason why setting aside some money to pay for these unexpected expenses is a real necessity.
But for some people, saving is not really that easy to do. People struggle to save and one of the culprits are these unexpected expenses too. This is according to the study done by PewTrusts.org. When you start saving money, something happens that forces you to dip into this emergency stash of cash. While we all know that it is what you are saving up for, it also puts you in danger of running out of money. There are instances when one emergency happens after the other. When that happens, you might still end up borrowing money just to survive a series of unexpected situations.
This is probably the reason why some people look into a Home Equity Line of Credit (HELOC) to help them survive a financial emergency. According to an article published on Forbes.com, the HELOC business is up once more by 30%. Among the reasons why people get it is for debt consolidation, education expenses, and even home improvement. But one of the surprising reasons for homeowners to get this is as an emergency line of credit. The article mentioned that people with no credit use it for liquidity purposes.
If you think about it, there is a certain logic in using the equity in your home as an emergency fund. After all, this is your money. It is just there and you are not using it anyway.
Pros and cons of using a HELOC as an emergency fund
But what is a HELOC and how can it help you during a financial emergency?
A HELOC is like a second mortgage that provides the homeowner with a revolving credit line. It works like a credit card. You have a credit limit that you can borrow. Whatever you borrow, that is the amount that you will pay – with the interest of course. As long as you do not reach the limit, you can have this money at your disposal whenever you need it – like during a financial emergency, for instance. And just like a credit card, if you do not use the money, you will not really pay for anything.
To understand if this is a wise way to finance an emergency situation here are the advantages that you can get out of a HELOC.
It gives you a sizable emergency fund.
The credit limit of a HELOC is based on 80%-85% of the appraised value of the house less the amount that is still owed on the first mortgage. For instance, if the home was bought for $300,000 and the owner has a balance of $200,000. If the house is appraised at $350,000, the calculation will be as follows:
$350,000 x 80% = $280,000
$280,000 – $200,000 = $80,000
In this particular scenario, the HELOC limit will be $80,000. That is a huge amount that you can have as an emergency fund. That amount can help you survive up for up to 2 years.
It frees your cash for investments.
An article from GetRichSlowly.org revealed that one of the reasons not to have an emergency fund is so you can invest it somewhere. If you try to understand the mindset of the author, you will realize that they have a point. Saving $80,000 and putting it in a savings account will be a waste. If you can put that money in an investment, it can earn you much more. Using a HELOC as your emergency backup plan will allow you to rely on a huge amount of money without wasting investment opportunities. You can use your extra cash to invest. It is a win-win situation.
It does not require a huge monthly payment.
Since your home acts as the collateral, the interest rate will be quite low. Not only that, some HELOC lenders will require you to pay only the interest of what you borrowed. Some will ask you to pay a minimum amount – like a credit card company does. But thanks to the low-interest rate, you can expect that the monthly payment will not be too heavy in your budget.
These advantages prove that using a HELOC for a financial emergency seems wise. However, you need to be careful of the following risks.
The house is in danger of foreclosure.
In the event that you are unable to pay off the borrowed money, that can cause you to lose your house. So be very careful when you are withdrawing money from this account. Make sure that it is only used for a real emergency and that you immediately come up with a plan to pay it back.
The interest rate can change from month to month.
Although the interest rate is low, it can change from one month to the other. Make sure you borrow only what is necessary because the interest rate for that particular month may be bigger than the next or the previous month.
The lender can freeze the HELOC if the value of the house goes down.
If you are relying on this alone, this can be a problem. When a financial emergency strikes, you might be left with no money to withdraw. Make sure you keep an eye on the housing market so you can be sure that the lender will not have a reason to freeze this line of credit. Of course, there are things that you can do to increase the value of your home. A little DIY here and there can help make the appraisal work in your favor.
Tips to secure your emergency finances through a HELOC
Using a HELOC as a means to get you out of a tough financial emergency is actually a good idea. However, you need to ensure that you will still make your finances secure. That way, you can go through a lot of unexpected events and still come out with a strong financial position.
Here are a couple of tips that will make a HELOC a wise financial move.
Have a cash reserve fund.
Have enough cash reserve to last for up to 3 months. At least, if the HELOC falls short, you have this cash reserve to look into. Or you can prioritize the use of this cash fund so you do not have to pay for any interest.
Be aware of the housing market trends.
Since the HELOC will rely on the value of your house, it is wise to keep tabs on the housing market trends. Remember that when the value of the property goes down, the lender can freeze your line of credit and it will be of no use to you.
Set strict rules when using the HELOC for emergencies
You have to set very strict rules for withdrawing from your HELOC account. Make sure that it is only for emergencies – nothing more. If you can save for an expense, do not use this account because it will cost you an interest amount. You have to be responsible for using this as your emergency fund to ensure that you will not compromise your home.
Know when the draw period expires.
In a HELOC, there is a draw period wherein you will be allowed to withdraw money. This is usually between 5 to 10 years. After that period, you will enter into a repayment period wherein you can no longer withdraw money and you have to pay off what you borrowed. Make sure your cash reserve fund is ready to take on a bigger burden during financial emergencies. Not only that, you should have a payment plan for the money you used on the HELOC.
Here is a video of Dave Ramsey discussing a plan to build your emergency fund and pay off your debt at the same time.