Reasons Why Your HELOC Can Be Your Emergency Fund

by Mike Holman

Debt Free Revolution published an interesting post today on why she likes to have a cash emergency fund and hates the idea of using your HELOC for your emergency fund. I thought I better write a post to address this idea since having a cash emergency fund is not always the best way to manage your money.

I use my home equity line of credit (HELOC) as my emergency fund because I believe that having too much cash on hand is not good money management.

Some problems with keeping a cash emergency fund:

  • tax inefficiency – the interest earned on the emergency fund is taxed at your marginal tax rate. If you earn 4% interest and have a marginal rate of 30% then your net interest is only 2.8%.
  • higher debt costs – using all your cash to pay down debts will keep interest on your debt lower than if you kept your money in an emergency fund.

Let’s look at an example:

Two homeowners – let’s call them Mike and Ana, both have mortgages of $200,000 at 5.19% and they have $10,000 each in cash. Ana likes the idea of keeping the $10,000 in cash as her emergency fund while Mike prefers to pay down the mortgage with the cash and will use a HELOC if an emergency comes up. Both mortgages have interest-only payments for simplicity.

So we have:

Mike – mortgage = $190,000, cash = $0.

Ana – mortgage = $200,000, cash = $10,000.

Scenario I

An emergency occurs after one year and both home owners have to cough up $10,000. Ana has the cash on hand and Mike borrows $10,000 from his HELOC.

How do the home owners compare in this scenario?

Mike – mortgage = $190,000, HELOC = $10,000, payments = $9861, total debt = $200,000.

Ana – mortgage = $200,000, cash = $280, payments = $10,380, total debt = $200,000.

Both home owners end up owing exactly the same amount however Ana has $280 (net of taxes -30%) of interest on the emergency fund but Mike has paid $519 less in interest which tips the scales to Mike and his HELOC emergency fund.

Scenario II

There is no emergency.

Mike – mortgage = $190,000, HELOC = $0, cash = $0, payments = $9861.

Ana – mortgage = $200,000, cash = $10,280, payments = $10,380.

In this scenario, after one year, Ana has netted $280 in interest but Mike has paid $519 less in interest on the mortgage so Mike comes out ahead.

What does it mean?

From the example above it should be pretty clear that using a HELOC is cheaper than using a cash emergency fund for some situations.

There are factors which should be considered which might make the cash emergency fund a better choice:

  • If the home owner doesn’t have a HELOC or other low interest credit then a cash emergency fund might be a better plan. Using a credit card as an emergency fund is not a good idea.
  • If the home owner doesn’t want to worry about exactly how much cash is in his/her account then having extra cash might be a good idea. Keeping a low cash balance can mean bounced cheques and late payments if the home owner is not organized.

Conclusion

There are some situations (like mine) where using your HELOC (or regular line of credit) as an emergency fund is the best way to manage your cash. On the hand there are other scenarios where a cash emergency fund makes more sense. It’s up to you to learn the various pros and cons of both methods and apply one method or a combination of both methods to your situation.

Some other posts on this topic:
Mr. Cheap is a fan of line of credits
The Financial Blogger says that cash emergency funds are wasteful.
The Money Gardener explains why he doesn’t like having cash.
Million Dollar Journey says he relies on a combination of cash and a line of credit in an emergency.
Never one to follow a crowd, Thicken My Wallet likes the cash method for emergencies – the more the better.

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{ 30 comments… read them below or add one }

1 MillionDollarJourney

Another great post Mike. Even though I do like using a LOC for an emergency fund, I usually have some cash kicking around also.

2 Four Pillars

Thanks FT – I edited the post.

3 MunEconomist

Great job in proving why credit is much better then cash just by the numbers. Although, I think that it makes no since to have cash lying around in an emergency fund. It depends on your risk tolerance and career path to which one you should choose.

If you are in career that has a lot of options in your surrounding area then less cash is needed. All credit would be best. If you are in the best job in your area then you should have cash reserves just in case you lose your job or need to travel to find work. If you have no other options or you are self employed then you should have almost all cash as your emergency fund.

So really I think it is more about your career path and chances of lower pay you would recieve from your new employer if you lost your job or cost to move to find new work. Point being the numbers can lead you to a poor decision if it doesn’t fit your lifestyle.

4 moneygardener

Mike, thanks for the link. Much appreciated.

Personally I don’t like the idea of borrowing money in an emergency, however technically if we are not using emergency funds to pay down mortgage debt then we are all borrowing money for some type of stash….

5 Four Pillars

ME – that’s a good point about the career.

MG – we are all borrowing money for some type of stash

Excellent way to put it.

6 CanadianInvestor

Would it not be the case that unless the cash pays a rate of interest above the borrowing rate of the mortgage, the HELOC/Mike will always be ahead?

7 Four Pillars

CI – you have to consider that the interest earned on the emergency fund is taxable at your marginal tax rate whereas the interest “saved” by paying down the mortgage is not.

The HELOC/Mike choice is better option when:

Interest on the mortgage is greater than (interest on EF minus income taxes).

The only time I can see the cash EF being a better option is if you have a mortgage locked in at a low rate and interest rates have risen significantly.

8 thickenmywallet

Thanks for the mention and the summary. Just for the record, I bury my cash in my back yard…

Seriously, it depends on the nature of the emergency. The issue with using any borrowed money to fund an emergency is what if the emergency is a shortage of cash? Then you keep digging yourself into a bigger hole. Just my 2 cents.

9 Nobleea

I think having an actual cash account for EF or prepaying the mortgage to increase HELOC is just semantics.
If one thinks of your mortgage as a savings account with an overdraft balance, then really it doesn’t matter where you put your EF money. Just as long as you are putting EF money in SOME account. How much EF money you sock away should be a function of the stability of your job, as has been pointed out above.

We have cash set aside every month for an EF, as well as mortgage prepayments, but it’s all going to the same account (mortgage), and we’ll use the HELOC in an emergency. Might have $500 hidden somewhere in the house for crazy emergencies.

10 Four Pillars

TMW – that’s the whole point of my argument – there is not much difference between having cash and debt or having no cash and less debt as long as you have access to a line of credit. You’re not digging yourself into any hole.

Nobleea – exactly!

11 Canadian Capitalist

From a strictly financial perspective, having a lot of money in an emergency fund is wasteful.

I had written an old post on this topic:

Link

12 moneygardener

I would have Nobleea’s $500 hidden in my house as well for ‘crazy emergencies’ but I’d probably be too tempted to go and grab it and invest it in dividend paying stocks.

13 Nobleea

MG: why would I hide my money in your house? Perhaps it’s safe, but I’m certainly not going to tell you where I hid it in your house.

14 Four Pillars

MG – lol, sounds like you might have a dividend problem.

15 Cheap Canuck

We keep only 3 months of bills in cash (mortgage, car payment, utilities). After that we have an unsecured line of credit for any emergencies (prime +1). Don’t like the idea of having more money than that sitting there doing nothing. Even in a high interest savings account, after tax and inflation the return is basically 0.

16 John

After today’s budget announcement, you now have to factor in holding emergency cash in the new TFSA. Although using a HELOC still looks like a better idea.

17 Four Pillars

John – the new budget change certainly changes the equation significantly for someone in a higher tax bracket.

I agree that the Heloc will still win but since the gap has closed quite a bit, the EF makes more sense than it did yesterday.

18 Brip Blap

I keep several months’ worth of expense in a cash account for two simple reasons: 1, as a consultant my cash flow can unexpectedly dry up (although an employee’s can, too, with all the layoffs going on) and 2, I just feel better having some cash. I know that it’s not the best money management but sometimes it’s about psychology… I prefer knowing that even if my income abruptly stops I have at least 3-6 months before I’d even have to adjust my lifestyle. That’s just the way my head works…

Steve

19 Wealth Manager

We don’t carry any cash or cash equivalents for this purpose, instead opting to use our 1-5 year portfolio in case of emergency. This portfolio is very simple – it contains one simple and relatively tax efficient monthly income fund. Besides emergencies, we also use it to build up funds to buy things like vacations, furniture, home projects etc.

We cap it at a certain amount, thus diverting further funds to the mortgage temporarily. Once this fund is tapped into for whatever reason, it’s stocked back up.

I feel comfortable with this approach as we have several backup strategies such as our 5+ year portfolio (more aggressive; all individual stock based), two RRSP’s, LOC @ prime and both of us working.

The key is good diversification – benefits us all in many ways.

Just my $02.

20 Frugalchick

Interesting post. I understand the math and the point of your argument but somehow I still feel better having cash on hand. We have a pretty big HELOC limit but there’s always that slim chance the bank could forfeit or take it back. And if an emergency strike, I wouldn’t know what to do then.

21 Debt Free Revolution

Mike-FP, you’ve gotten quite a bit more commentary on this than I have LOL I’m still trying to work over these numbers, and am very curious at your example. Why an I/O mortgage? I have never understood why someone would get one of those (I have this thing against leasing and interest-only). Also, does Canada tax you on savings accounts? Remeber I am in the “zero” tax bracket down here in America right now, although I hope to rise up to the 10% bracket upon college graduation. If y’all are taxed on savings, that would explain your preference for a HELoC.

22 Four Pillars

DFR – thanks for the comment.

I used an interest only mortgage just to simplify the example a bit.

Canadians get taxed on interest on their savings at their marginal tax rate which is the same rule as in the US. However yesterday the government announced a new tax-free account similar to a Roth which removes this problem.

If you don’t pay any tax on the interest on your savings then the question is just what is the difference between the interest rate you can get on your savings vs the interest you save by paying down your mortgage. Since the difference is much smaller in that case, the argument for a cash EF becomes much stronger.

Mike

23 Jon

Hey,

Two comments, but I don’t know how much they apply to Canada.

First, from my understanding, HELOCs can be denied or revoked. If the value of your house has decreased, then you could not access your HELOC. (See this blog for example.) I bet there are similar provisions for if you lose your job.

Second, you can put your money into municipal bonds instead of a savings account, and the interest is tax free. There are municipal bond funds with a “tax equivalent” yield of 5.5% or 6% — heavily dependent on your tax bracket I suppose. (See this article for example.)

24 Mr. Cheap

Jon: That certainly is a danger, but similarly having a house “under water” when it comes time to renew your mortgage is a danger. If you’re applying “emergency fund” money to your mortgage, that creates more equity for your HELOC to tap and makes it less likely that they’ll deny draws on it. Obviously if you’re in a market with a plunging property value, putting emergency money into your house that you can’t draw back out isn’t the smartest course of action (but the risk of property values hitting RIGHT as your emergency hits and your HELOC IMMEDIATELY being shut down for draws seems fairly unlikely to me – at that point you get a cash advance from your credit card or sell some of your long term investments and pledge never to leverage so aggressively ever again.

In terms of municipal bonds – no thanks to a 5.5% or 6% return (blah!) – I’d just go for a savings account or a money market account and get 100% liquidity.

25 FinancialNewbie

Just a question…in the simulation shouldn’t we also factor in the effect of inflation on cash? After tax and inflation the gain on cash is quickly approaching zero right?

26 Four Pillars

FN – yes, it is.

27 susan

Let’s see. I have a financial emergency and I get further in debt? Doesn’t make much sense to me!

I have 6 months cash combined in my savings account and a money market account. I can sleep easily.

28 nobleea

But that’s just it, you wouldn’t be going further in to debt since instead of putting your emergency funds in a savings/money market account, you had put it against your mortgage.

Saver: 200K mortgage, 20K savings account
Anti-debt-er: 180K mortgage, 0K savings account.

They both put aside the same amount for emergencies, the difference is in where you put the savings.

The overall debt level is the same. It’s just semantics.

29 James Carsey

There is an important problem with the HELOC-for-emergency not mentioned here. You are assuming the line of credit will always be available. In a credit crunch, what is happening now, is many sorts of credit are withdrawn and become unavailable. This could happen to your line of credit, it could disappear if the bank re-evaluates your risk as a borrower.

In fact in times of financial market turmoil, which is the sort of situation that my cause an emergency for you (loss of job, for instance) those same conditions could result in your line of credit being withdrawn.

So what would you do then, if you have zero cash and no available credit?

Terms of credit CAN and DO change. Nothing beats cash in the bank, that is your money. Do not assume your line of credit will always be there.

30 Four Pillars

Thanks for the comment James.

You’re correct that LOCs are not guaranteed but I think the odds of a LOC disappearing on you are related to your financial situation. If you are maxed out then you have a higher risk of losing your LOCs.
Another factor is the HELOC – in Canada these are legally registered so while I would expect a bank to be able to cancel it, it wouldn’t be very easy.

My point is that most people who have fairly good finances don’t have to worry about losing their LOCs or HELOCs.

Mike

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