Using a HELOC for an emergency fund
|  Dear
Dr. Don,
What do you think of having a home equity line of credit
(HELOC) on your home? My parents have no money saved at all but they have about
$300,000 in equity in their home. Would it be wise to open a line for $25,000
just to have for emergencies?
-- Ruben Refuge
 Dear
Ruben,
I think a home equity line of credit can be a realistic alternative
to an emergency fund, although there are some downsides to this approach. First,
it's common for the line to require a minimum withdrawal when the loan closes.
So on top of the closing costs for the HELOC, the homeowner faces the interest
expense on this minimum draw. Since most lines of credit have a prepayment penalty,
the homeowner has to find a place to invest the money to mitigate that interest
expense.
If the minimum draw is $10,000, the interest rate
is at 8¼ percent, and your parents can only earn 5¼
percent on savings, there's a 3 percent spread between what they
pay and what they earn. That's $300 per year. Let's say that closing
costs were $800. Ignoring any tax impact from the potential mortgage
interest deduction on their taxes, they spent $1,100 in year one
to have a line of credit in place for financial emergencies. If
an emergency fund is typically sized at three to six months worth
of living expenses, you have to ask what percentage of the emergency
funds $1,100 represents.
Another issue is that being able to draw against the
line is only allowed in the early years of the loan agreement. As
the ability to draw against the line expires, your parents would
then have to pay off the old line and take out a new line to keep
having the money available.
There's enough variability in closing cost, interest
expense, prepayment penalties and draw requirements that it's worth
it to compare
different HELOCs. I suggest doing this without filling out an
actual loan application because they don't want a series of loan
applications on their credit reports. Just ask the lender for its
HELOC terms. Low closing costs, low interest expense, long draw
periods and short prepayment periods all contribute toward making
a HELOC a viable alternative to establishing an emergency fund.
Finally, this alternative is for people with the financial discipline
to use the loan for financial emergencies only. It's not meant to
be a substitute for a credit card. People who can't keep their credit
card balances under control probably shouldn't use a HELOC as an
alternative to an emergency fund.
To ask a question of Dr. Don, go to the "Ask
the Experts" page and select one of these topics: "Financing
a home," "Saving & investing" or "money."
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