 Using
HELOC for emergency fund
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 Dear
Dr. Don,
My wife and I have just enough in our "for
emergencies" savings account to pay off money borrowed from
a home equity line of credit. The only other debt we have is our
mortgage. Wouldn't it make sense to pay off the loan and start building
our savings again? The interest rate of the savings account is half
that of the interest rate on the loan. If/when an emergency comes
up we will have either built up the savings enough and/or could
use the line of credit.
-- Kevin Creditline
 Dear
Kevin,
Having a line of credit in place can mitigate
the need for emergency fund savings. A home equity line of credit
(HELOC) can be paid down and then borrowed from again as the need
arises, at least through the initial term of the loan. The monthly
payment is interest-only, based on the current rate of interest.
As a variable-rate loan, the interest rate on the HELOC will vary
with changes in the interest rate the loan is based on. Most HELOCs
are based on the prime rate, and the interest rate will change with
changes in the prime rate.
If you use your emergency fund to pay off the HELOC,
you eliminate the interest expense on the line of credit but give
up the interest earnings on your savings. If you use the mortgage
interest deduction on your taxes, then the relevant comparison is
the after-tax cost of your mortgage debt versus the after-tax return
on your savings.
You can approximate these after-tax rates by multiplying
the interest rate by 1 minus the tax rate. For a homeowner with
a 6 percent mortgage in the 25 percent marginal federal income tax
bracket, the after-tax cost of mortgage debt is 4.5 percent. (6%
x (1 - 0.25) = 4.5%) You can do a similar calculation for the after-tax
return on the emergency-fund savings. This example doesn't include
the impact of applicable state or local income taxes. (Though not
completely accurate, you can approximate the impact by adding any
applicable state and local income taxes to the marginal federal
rate when calculating the after-tax rate.)
Before paying off the line of credit, review your
loan documents or talk to your lender to make sure that your HELOC
doesn't have a prepayment penalty. Also, at some point in the loan's
life, the line of credit may no longer be accessible for additional
drawdowns. Not a good thing if you're counting on it as a source
of funds in a financial emergency. Know your loan terms.
Your emergency fund should have enough money
available in it to cover three to six months worth of living expenses.
Having the HELOC available can reduce emergency-fund requirements.
Figure out how long it will take you to replenish your emergency
fund with monthly payments to that account. Making the payments
automatic transfers, from your checking account, will ensure that
you keep on track. The Bankrate guide, "Building
an emergency fund," has more on building and investing
your emergency fund.
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