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Dr. Don Taylor, CFA, advice columnist 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

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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."'s corrections policy-- Posted: Feb. 20, 2007
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