February 27, 2008, 7:00 am

Why Using a HELOC as an Emergency Fund

by: The Financial Blogger    Category: Personal Finance
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One of the good feelings when you have a blog is when people link back at one of your article. I always look at the blogger who linked to my post. It is usually very positive. Usually. Two days ago, when I logged into my blog to post updates, I noticed that one of the link was called “I think this is bad money advice. I thought I would give a little bit more interest into this post written by Ana at Debt Free Revolution.

money house

Four Pillars brought a good argument on his blog yesterday and I’ll bring another one today as well.

Let’s take 2 people again, Mike (it’s not my fault if FP and I both have the same name 😉 and Ana. They are both making 50K and wish to have 25K available in case of an emergency (6 months salary). They also have the ability to save $377 per month and both wish to retire in 30 years.

If Ana wish to have a 25K emergency fund, she would need to invest $377 per month over five years at a 4% rate of return. As this account needs to be highly liquid and the investment must be stable overtime, I assume that the maximum rate she could get would be a 4% savings account at ING. If she would be to invest in more aggressive mutual funds or stock, she would become very dependable of the market and this is not what we want when we are looking for an emergency fund.

After 5 years, she leaves the 25K into the same savings account earning 4%. She can now use the $377 and invest in a more aggressive portfolio (giving 7%) since she will be retiring in another 25 years. At retirement (so 30 years later), her 25K into her savings account is now at $66,6K and her retirement account show a balance of 305,4K for a total amount of 372K.

Mike doesn’t want to save for an emergency plan as he will use his HELOC if he has any problem along the way. Then, he starts investing his $377 at 7% right away. At the end of the 30 years, he will have 460K into his investment account.

So if you depend on a HELOC for your emergency fund, you will get $88,000 in your investment account at retirement. This is the equivalent of 50 years of interest on $25,000 debt at a 7% interest rate.

So I think that everything goes well, you will make 88K more by not having an emergency plan. If you have to withdraw 25K from your line of credit, it will cost you $1,750 per year at a 7% interest rate charge.

Ana was also mentioning death and severe injuries in her post. These incidents should not be covered by an emergency fund but by insurance as 25K will be far from enough to cover for the financial lost of your spouse’s income.

Please note that this was a quick calculation. In order to be precise, I would have to calculate when and for how long Mike and Ana would need their 25K and also to take in consideration that the tax rate would be higher on the interest earned in the savings account than the investment account (which would include mostly dividend and capital gain).

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Comments

Mike2, I appreciate the link and the conversation. I’d also like to point out cash emergency funds are to be saved up quickly 🙂 I am starting in on building mine now that I have paid off all my consumer debt. So instead of $377 per month and taking four years, I will be saving $1500-2200 per month, and would reach $25k in maybe one year (I am actually intending to save $10k more by the middle of summer).

And when I mentioned death, I said “death in the family.” Also, I speak from experience when I say it is a pain to get any form of disability going after an injury, and in cases of an accident (usually of the auto variety) insurance companies tend to try to lowball with their initial settlement offer. I notice you are Canadian (as is FP-Mike) and that may be at the root of our little debate since I am American and under a different insurance, disability, medical, and banking system.

Why does an emergency fund of six months need to be in cash? If the emergency fund is to cover expenses while you can’t work then all six months doesn’t have to be totally liquid. Maybe just one or two months with the rest in something a little less liquid.

If, on the other hand, it is to cover large unexpected bills then a HELOC is totally compatible. You’re still working, you just had a large bill. Pay for it from the HELOC, and then decide how to repay the HELOC .. either from investments or over time from the paycheck.

Your resources are all your assets combined. You put them in a form that makes the largest benefit for you, which is not usually cash. Borrowing, selling, buying, working, bartering, are all ways to convert assets into benefits you need at the time. Having a huge pile of cash just doesn’t seem to be optimal.

Hi Mike,
I kind of see what you’re saying here and I agree with you, although depending on a HELOC for emergency funds still makes me a little nervous. One of the main reasons why was a situation posted on another PF blog (sorry, i cannot seem to remember at the moment whose it was): the person was depending on his HELOC for emergency funds and using it like a chequing account (sort of like the ManuOne account here in Canada), so he was paying everything towards the outstanding portion instead of, say, paying half into paying back the HELOC and putting half into cash savings. Unfortunately, the housing market in his area plummeted and the bank cancelled his HELOC because he no longer has enough equity in his house based on the current market value. Now, granted he had actually used his HELOC rather than just saving it for an emergency and the US housing market isn’t doing as well as the Canadian housing market, but who’s to say that we won’t have the same problems in the future and the bank won’t cancel your HELOC? I guess it depends mostly on how much equity you have in your home. If you have the bare minimum, but enough to qualify for the HELOC, perhaps it’s not good to rely on it in the event of an emergency.

Wow, I wrote HELOC a lot! I love acronyms LOL

B&C

by: The Financial Blogger | February 27th, 2008 (9:37 pm)

Ana;
You may be able to save money at this pace, but you will probably agree that most people can’t (I barely make this much net of taxes!).

I agree with you when you say that we are living in two different systems in term of taxation, banks and insurances. I guess this is the beauty of having bloggers communicating to each other; we can express opinions and learn more about what is going on in the world 🙂

CR;
I just can’t agree more with you, having one of two months of income in a savings account won’t hurt you much while the HELOC can be used for major events.

B&C;
That’s crazy, I actually never considered having the bank canceling my HELOC… On the other side, mine is at 80% of my property value so I have quite a buffer. If I understand correctly, you could get a 100% HELOC in the US. This would definitely be a problem if banks start canceling them!

Interesting take on this FB.

Ana – we are not all named “Mike” up here. 🙂

CR – good point about the liquidity of a large emergency fund.

B&C – good point as well – the blog post might have been Queer Cents http://www.queercents.com/2008/02/04/countrywide-suspending-equity-lines-of-credit-heloc/

by: The Financial Blogger | February 28th, 2008 (7:34 am)

Ana – some of us are named michael or mikael as well 😉 we only have 3 different names in Canada 😉 LOL!

FP-Mike, I never said everyone up there was named Mike…but both you are named Mike, both wrote a rebuttal to the same blog post within 24 hours of each other! Oh, and you’re both Canadian LOL Add to that a cousin and an uncle and a couple friends here locally, plus about a handful of American Mikes who are pf bloggers … and I gotta do something to keep y’all straight 😀

Or are you two just yanking my chain here…?

Oh, Mike-TFB (is that better?) when you say you barely net that much after taxes, is that in USD or in Loonies? If it’s in Loonies, you probably make more than we do now….

As a person who firmly believes that emergency funds are wasteful (low returns compared to the alternatives), allocating the money that would otherwise be parked in a low retrun emergency fund to other investments wins my vote.

An additional point in favour of this strategy is that it gives you a choice: if you need the money you can draw on your HELOC or you can sell some of your investments. Which one? That will depend on your circumstances at the time.

by: The Financial Blogger | March 1st, 2008 (2:20 pm)

Ana; this is in loonies so it might become interesting in a year or so 😉

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