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Using HELOC for emergency fund

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

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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.

Bankrate.com's corrections policy
-- Posted: Sept. 12, 2005
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