A home equity line for sinking finances?
By Greg McBride, CFA • Bankrate.com

One often-heard bit of advice for homeowners involves having a home equity line of credit available in case of a job loss or other financial emergency. But there are important warnings to attach to such advice, as the consequences cannot be ignored. An equity line of credit may well be a suitable complement, but never a replacement, for an emergency savings account.

A home equity line of credit, or HELOC, is a variable-rate product similar to a credit card. But unlike a credit card, the loan balance is secured, which means this is not the type of obligation the homeowner could walk away from in the event of default or bankruptcy. One of the primary attractions of the HELOC is its low rate, a rate that is lower on an after-tax basis because the interest is tax deductible.

Like a credit card, the minimum payment requirement is modest relative to the debt incurred. Many home equity lines of credit require only the interest to be paid each month while the balance can continue to revolve. For households needing to plug the hole in the financial boat until finding work that pays enough to meet the household expenses, this may seem inviting.

However, utilizing a home equity line of credit is not the same as drawing upon accumulated assets such as cash to meet financial obligations. Using a HELOC is borrowing, and it involves using an asset -- the equity accumulated by the homeowner -- as collateral for a loan. This loan, like others, must be repaid with interest. The interest cost, even at today's low rates and with the benefit of tax deductibility of interest, outweighs the foregone interest on a savings instrument. In other words, funding a household deficit is cheaper by using accumulated savings that would otherwise be earning 1 percent or 2 percent at this point in time, than by borrowing at what amounts to approximately 3 percent on an after-tax basis.

Given the very tangible collateral securing the loan, using a HELOC as an emergency back-up plan means heightened consequences of delinquency or default. This consideration is especially worthwhile in an environment where the average period of unemployment is more than 20 weeks and job creation remains anemic. Even without the risk of default, there can be other consequences when a homeowner reaches for an equity line as if it were a lifeline.

In a period of joblessness or drastic pay reduction, the revolving balance can quickly snowball as household expenditures are paid via equity in the home. This can quickly create an imposing debt load that ultimately must be repaid. Repaying the debt may take years to accomplish, even after the homeowner returns to full-time work. Often, displaced workers end up returning to the workforce at a pay rate significantly less than what they earned before, hampering the ability to rapidly retire debt accumulated during unemployment.

For households without accumulated savings or other financial assets that could be used to meet expenses, a home equity line may be viewed as a last resort. Indeed, a HELOC may seem like your only option if you lack accumulated savings, but it merits careful consideration. Ideally, it is a supplement to, rather than a replacement for, an emergency savings account.

Greg McBride is a financial analyst for Bankrate.com.

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