If you have a house, car or child, you are bound to have an emergency pop up at some time. For years, financial gurus have been advising people to maintain dedicated emergency funds. The conventional wisdom is that one should have a fail safe that would cover at least three months-worth of expenses.
In spite of this advice, more than a quarter of Americans have no emergency fund whatsoever, according to the Bankrate Financial Security Index. Many people don’t feel like they can afford to save up or they want to allocate any cash they have towards paying off existing debt. Most savings accounts yield very little interest—less than the rate of inflation. Paying off existing debt first can make more financial sense than putting that money into a savings account.
However, you might have access to money that could help you stay afloat during a financial emergency and not even know it.
A Home Equity Line of Credit, or HELOC, can provide the liquidity that you need during an emergency. It is a line of pre-approved credit based on the equity in your home, which have a variable interest rate. These HELOCs are usually paid off over a period of 10 years.
Some financial gurus, including Mr. Money Moustache, recommend using a home equity line of credit as an emergency fund. Mr. Money Moustache argues that paying off existing credit card debt is an emergency and should take priority over setting up a cash emergency fund.
So, is it a good idea to use a HELOC to help you survive a financial emergency? After all, there are pros and cons to the practice. Let’s take a look at a few of each.
Advantages
The Interest is Tax Deductible
Unlike most other types of loans, the interest on an HELOC is tax deductible. Just like your mortgage, you can deduct the interest that you pay on an HELOC—up to $1 million if the money if used for a home improvement. So, if your air conditioner breaks and you use the money for a new one, that interest would be tax deductible. However, if you use the money to repair your car, then only $100,000 is deductible.
It might save you money
If you have existing credit card debt, you will save money by paying your credit cards off versus putting cash into a savings account. Credit card interest rates are higher than what you would earn on most savings accounts.
So, putting your cash into a savings account instead of paying off existing credit card debt will cost you more money. Also, the interest on an HELOC is typically much lower than the interest on a credit card. In this situation, it makes sense to pay off your existing high-interest debt first. In fact, paying off your credit card can be one of the best investments that you can make.
Disadvantages
Too Much Temptation
Having a large line of credit at your disposal can prove to be too much temptation for a lot of people. Those with less financial discipline may find themselves using it to pay for a vacation or buy a boat. You have to have a lot of financial restraint to use your HELOC as an emergency fund.
It Could Trigger a Foreclosure
If you have an emergency and then tap into your HELOC, you might be putting your home at risk. If you have a major life catastrophe such as a job loss and cannot pay back your HELOC, the lender can foreclose on your home.
Ultimately, HELOCs require serious financial restraint. The best option is to pay off existing credit card debt and then stash some money into a cash emergency savings fund. After you have a funded savings account, you can rely on a home equity line of credit for additional emergency savings provided you keep it at a zero balance except in the case of a real emergency.
Regards,
Ethan Warrick
Editor
Wealth Authority
