Financial emergencies aren’t fun. They can put you at risk of losing your home, cars, and your credit. Staying prepared is the key. But, today it can be hard to save enough. Financial demands and a higher cost of living make it difficult. If you can’t save enough on your own, you have options. One such option is the HELOC or home equity line of credit. There are pros and cons to this method. But, if you use it responsibly it can help you stay out of a jam.
What is a HELOC?
First, let’s look at how a Home Equity Line of Credit works. Most lenders allow HELOCS for as much as 80-85% of the value of your home. Let’s say you have a first mortgage for $150,000 and your home is worth $300,000. This means you have 50% equity in your home. Of that 50%, you may be able to borrow some as a HELOC. On a $300,000, many lenders will allow up to $240,000 in mortgages. Since you already have $150,000 out, this leaves you with $90,000. This is a great sized emergency fund.
The difference between a HELOC and a standard mortgage is the fund disbursement. A first mortgage disburses the funds to the seller or current lienholder. A HELOC disburses the funds to a checking account. If you don’t touch the money, you don’t have to pay anything. But, if you need the funds, they are there right away. You write the check just like you would from your checking account.
Once you use your HELOC funds, you pay interest on it. For the first 10 years, this is all you owe. This doesn’t mean you can’t pay the principal on the loan, though. If you choose to pay any principal back, you can use the line again. It works much the same way as a credit card. You always have a minimum payment that covers the interest. It’s up to you to pay the principal. If you wait, your principal will become due in 10 years. This is the repayment period. You can no longer draw the funds from the account. Instead, you make principal and interest payments amortized over 20 years.
The Benefits of Using a HELOC for Emergencies
There are many benefits of using a HELOC for emergencies.
- Liquidity of the account – Once you secure approval and fund the loan, you have access to the funds. Like we said above, you write a check for any expenses. Some lenders also provide an ATM card for access to the funds. This provides immediate access and less stress in an emergency.
- You have low payments – Interest is often low on HELOCs. Lenders have the benefit of using your home as collateral. Because of this, they can provide lower interest rates. It is a variable rate, though, so watch out for that. Your lender will tell you the index your rate is based on. They will also tell you the margin you must add to the index. This gives you the current rate for your HELOC. You can watch the index so you have an idea of how much interest you may pay on your funds if you use them.
- Keep your savings intact – Sometimes emergencies happen that cost more than what we have set aside. Let’s say you were only able to save 3 months’ worth of expenses and your emergency wipes the savings out. Now you don’t have savings to fall back on. If something else happens before you can save again, you could be in serious financial trouble. Instead, using the HELOC, you leave your savings alone and still care for the issue at hand. After the crisis passes, you can focus on adding to your emergency fund. Once you see how emergencies can affect your finances, you may be more motivated to save.
The Downsides of Using a HELOC for Emergencies
There are also a few downsides you should consider before using your HELOC for emergencies.
- Your home is at risk – This is a big one. Your home is the collateral for your HELOC. If you use the entire amount and can’t make the payments, your home may be at risk.
- Your payment increases after the draw period – You can’t predict the interest rate when your draw period expires. You also can’t predict your financial situation in 10 years. After the draw period, your repayment period starts. This means principal and interest. If you are struggling financially already, this could be a problem.
- Your home value may drop – Your lender always has the option to freeze your HELOC. Sometimes they do this due to falling housing values. If your value falls enough, the lender knows they don’t have the same collateral. They can freeze your account. This may leave you without an emergency fund.
Consider Your Options
Before you decide to open a HELOC for emergencies, consider your options. Look closely at your financial picture with these questions:
- Do you have money set aside? If so, how much? Base it on your monthly expenses. A good rule of thumb is to have 6-12 months of expenses set aside.
- Do you have enough equity in your home? If you only have a little equity, you may not be able to secure a high enough HELOC to serve as a true emergency fund.
- Can you handle a variable interest rate? Your payment may change from month-to-month.
- Have home values in your area remained stable? If you worry about the value of your home dropping, you could lose your HELOC.
Knowing your options and how you feel about the risks of a HELOC will help you make a decision. A HELOC can be a great way to fund your emergencies. You must be careful though. Don’t get in over your head. You must have a strategy or rules in place. Don’t use the HELOC funds for anything except an emergency you can’t afford. Using it for anything else just puts you in the same position you were before you had it.