Renovation, debt consolidation, or – if you need anything, a Home Equity Line of Credit (HELOC) can be useful. But what if you want to open HELOC for no particular reason? There is a financial idea that recommends you store your HELOC in spare for rainy days. In other words, don’t establish it for a specific purpose.
Interesting strategy – but like any other tactic, it has advantages and disadvantages. Let’s analyze the pros and cons of using HELOC as an emergency fund.
How to use HELOC as emergency funds
Heloc is dormant, but ready when needed, is like hiding a Himit credit card in your back pocket for unexpected expenses. The truth is that HELOC works just like a credit card. Once you apply and your line of credit is approved, you can tap it at your discretion, amount, and schedule of your choice.
“In some cases, Heloc Underwriter provides a brief explanation of how funds are not used even if they are not used immediately,” said Jaime Schmidt, sales manager at Cornerstone Servicing, Consumer Direct. However, the rationale is not binding and there is no obligation to use any immediately available funds (explained below with a few exceptions). In fact, “Many borrowers should not open and use HELOCs, they keep it in case of emergency or unexpected costs.
“Think of it like a financial safety net,” says Andrew Lokenauth, a personal finance expert who has personally used Helocs as a backup emergency fund for many of his clients for years and has helped many clients do the same. “You simply set up your Helock, but don’t draw it right away,” he explains. “Sit there and ready to use if necessary.” It doesn’t cost you either. There is no minimum payment because “you will only pay interest (accrue and) on what you actually borrow.”
Among the benefits of using HELOC in emergencies and unexpected situations, you will probably pay much less interest than on a personal loan or a credit card charge for a comparable amount. Let’s take a look at some scenarios.
Example 1: Sudden repair costs
Let’s assume you own a $400,000 home with a $200,000 mortgage. You can qualify for $100,000 HELOC (80% of your stock, minus what you’re borrowing on a mortgage) at an adjustable rate of 8%. Open Heloc but keeps the balance zero.
But two years later, the furnace would cost $12,000 to kick the bucket and replace it. You withdraw funds from your HELOC. During the draw period, you will be obligated to pay interest only on the borrowed dollars (although you may pay the principal if necessary). If you choose that, you will pay around $80 a month for six months (a total of $480). In the meantime, you can save money to pay off the principal. Delay the principal’s repayment until the 10-year repayment period begins in the fifth year of the HELOC period (and three years after borrowing the initial funds).
These 10-year monthly payments are $145.46 (assuming an average rate of 8%), totaling $17,455 in 120 months. The total interest paid in this scenario is $5,935. In contrast, credit cards charge an average of 20% interest, so you should start paying at a minimum of $216 per month. Assuming it took the same amount of time (156 months in total) to resolve the debt, you would be paying $21,761 overall.
Example 2: Unemployment
Another scenario is: Open a $120,000 HELOC with a 8% fluctuation rate. A few months later, you will be fired from your job and will need to borrow $6,000 a month to cover your living expenses.
“In this example, you’ll pay around $40 a month with interest-only payments, which totals around $200,” said Steven Glick, director of mortgage sales at real estate platform Homeabroad. “We use HELOC to cover all costs over five months, but we get a new job, pay back $30,000 (approval) for six months and a total of five years.”
To repay the principal, he would have to pay $608.29 a month over five years, totaling around $36,497. This means that the total interest paid from start to finish is around $6,697 (assuming an average of 8%). If you win a five-year personal loan of $30,000 at the current 12% rate, you will be paying $667 a month and a total interest rate of $10,040.
The advantages of using HELOC as an emergency fund
There are several benefits to setting up HELOC as a reserve fund instead of a savings or investment account and using it on a credit card or other loan.
- Fast Access. Like mortgages, Helocs can take weeks to get it, so establishing one in advance can save you time if you have a sudden need. “We will have immediate access to cash in emergencies without liquidating taxable assets or gaining market returns,” said Travis Ericson, a mortgage broker in Mesa, Arizona, Bonelli Financial Group.
- Greater limit. Helock could be rich because you are using it as collateral because you rent your home A considerable source of cash (Serious 5 or 6 numbers). How easy is it to get a credit card with a $50,000 limit?
- Cheap debt. As a protected debt, HELOCs have much lower interest rates (repeated as mortgages) than credit cards and personal loans. “My HELOC rate is around 7.5%, but credit cards usually charge over 20%,” says Lokenauth.
- Flexible borrowing. Everything is borrower, whether you draw, when you draw, and when you pay it back.
- It will not affect your credits. Your credit score can drop slightly for the short period of time after your application, but without HELOC, it should not have a negative impact on your credit history or reports.
Cons of using HELOC as an emergency fund
Of course, this strategy also has some drawbacks.
- Time sensitivity. HELOC is best used as long as the draw period lasts. It’s at most 10 years. Once the repayment period begins, you will not be able to borrow it.
- Fees may apply. You will probably have to pay the closure fee to establish a Heloc that could be 5% of your credit line. Many people carry maintenance fees ranging from $50 to $100 a year. Some lenders may even charge inactivity fees.
- Use it or lose it. Some lenders may choose to reduce, suspend or shut down their credit line if 18-24 months pass without a tie. Also, when a large market slump and the value of the home drops, lenders often have the option to freeze or reduce their credit line.
- Unpredictable payments. Most HELOCs charge variable interest rates. This means that once you start drawing your funds, your repayment amount can fluctuate over time.
- Your home is in danger. HELOCS is a serious commitment. You are pledging your home as collateral. So if you don’t make the payment as promised, you could lose it.
How to find the right “reserve” helock
Comparison shops are always important when you’re in the HELOC market. “Compare at least three to four different lenders,” says Lokenauth. “We’ve found that local credit unions often offer the best deals.”
However, in the case of the Emergency Fund HELOC, you would like to pay particular attention to the terms. We aim to choose lenders who allow minimum interest payments, as they do not charge annual maintenance or inactivity fees. “This can be a slightly higher rate, but it’s worth it if you’re not sure if Heloc will be used,” Erickson says. He also recommends you choose the longest possible draw period to avoid falling into the trap of Murphy’s law that ends when your need arises.
Obviously you’ll want to avoid lenders who need a first draw. Also look for generous credit restrictions. “We’re targeting credit lines covering between $50,000 and $100,000,” Glick recommends. Of course, the size you can get depends on your stock pile and mortgage balance, creditworthiness, and the value of your home.
Also, be sure to check fine print carefully for credit line reductions or freeze clauses, especially as related to Heloc’s inactivity. “And make sure it takes time for your lender to explain all the details of your credit line, so you can get plenty of information before you make a decision,” adds Erickson.
Who is the best way to use HELOC as an emergency fund?
It makes sense to open a HELOC that you plan to use only in a pinch. As long as you are aware of the associated risks and can afford to pay the associated costs. In general, good candidates for HELOC tend to have strong financial (high credit scores), stable income, and very little debt. In particular, they paid a lot of their mortgage, which means they built up attractive equity stakes.
“But remember that when you actually need money right away, it can be much more difficult and it can take longer to approve HELOC,” Lokenauth says. “So consider setting one when the time is good.”
