HELOC as emergency fund - what am I missing?

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Sportswhiz00
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HELOC as emergency fund - what am I missing?

Post by Sportswhiz00 » Fri Jan 09, 2015 7:05 pm

I have a mortgage balance of $500,000 with almost the full thirty year term remaining and can refinance to a $400,000 thirty year first mortgage and a $100,000 HELOC, both with interest rates slightly lower than existing rate. If I need $100,000 in emergency funds, the way I see it, it makes more sense to pay off the HELOC and keep it open than to keep the $500,000 mortgage and have the cash sit in the bank. If I need to use it, then it will put my combined HELOC and first mortgage balance up to $500,000, and I'd be in the same position as if I had the full $500,000 first mortgage and spent all of the $100,000 cash.

It seems to me that the advantages of the HELOC are three fold. One, my mortgage rate is lower as compared to my existing mortgage. Two, while I do not need the emergency funds I will effectively be earning a better guaranteed return because the mortgage rate is greater than interest on cash or short term bonds. Three, I would have increased cash flow while not using the emergency funds because the mortgage would be based on $400,000 rather than $500,000. The only downside I see is that if I actually have to tap the HELOC the rate could be higher than the mortgage rate (although this would require a significant upward movement in rates lasting a long time to offset the current lower rate on the HELOC vis a vis the first mortgage).

Thoughts?

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Alskar
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Re: HELOC as emergency fund - what am I missing?

Post by Alskar » Fri Jan 09, 2015 7:35 pm

My HELOC sits open with a zero balance so I pay no interest on it. It is a line of credit that I use as part of my emergency fund. In this regard, I am very unBoglehead-like. I cannot tolerate having large sums of cash earning near nothing just in case I need it someday. It seems like I'm trading a potential loss for a certain loss (earning less than inflation) which is completely and totally unacceptable to me. YMMV.
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Spirit Rider
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Re: HELOC as emergency fund - what am I missing?

Post by Spirit Rider » Fri Jan 09, 2015 7:43 pm

While a HELOC or unsecured credit lines can be effectively used when you need funds, they can not be depended on for first tier emergency funds.

In the midst of the recent financial crisis, some HELOCs were revoked and some unsecured credit limits were significantly reduced. This came at the worst possible time for some. Not only were portfolios devastated, but many lost their jobs and became long term unemployed. The foreclosure crisis wasn't just based on sub-prime loans, but included many well off individuals who didn't have access to significant liquid emergency funds.

I'm not one who believes that your entire emergency fund needs to be in bank accounts (savings, CDs, etc...). In fact I almost exclusively used 0% unsecured credit to survive during the Dot Com collapse. However, it was an optional choice to use 0% credit before hi-yield savings and especially to save my 3%+ I Bonds.

I had significant 1st tier in hi-yield savings accounts, 2nd tier in I Bonds. The availability of essentially free credit was pure dumb luck. Don't assume that lightening can't strike twice. Have some guaranteed liquid emergency funds.

john94549
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Re: HELOC as emergency fund - what am I missing?

Post by john94549 » Fri Jan 09, 2015 7:51 pm

By definition, a line of credit is not a fund. You might wish to check the terms and conditions of the line. I suspect it can be reduced (as to un-tapped amounts) or even eliminated, at the pleasure of the extender of the line.

cherijoh
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Re: HELOC as emergency fund - what am I missing?

Post by cherijoh » Fri Jan 09, 2015 10:59 pm

Sportswhiz00 wrote:I have a mortgage balance of $500,000 with almost the full thirty year term remaining and can refinance to a $400,000 thirty year first mortgage and a $100,000 HELOC, both with interest rates slightly lower than existing rate. If I need $100,000 in emergency funds, the way I see it, it makes more sense to pay off the HELOC and keep it open than to keep the $500,000 mortgage and have the cash sit in the bank. If I need to use it, then it will put my combined HELOC and first mortgage balance up to $500,000, and I'd be in the same position as if I had the full $500,000 first mortgage and spent all of the $100,000 cash.

It seems to me that the advantages of the HELOC are three fold. One, my mortgage rate is lower as compared to my existing mortgage. Two, while I do not need the emergency funds I will effectively be earning a better guaranteed return because the mortgage rate is greater than interest on cash or short term bonds. Three, I would have increased cash flow while not using the emergency funds because the mortgage would be based on $400,000 rather than $500,000. The only downside I see is that if I actually have to tap the HELOC the rate could be higher than the mortgage rate (although this would require a significant upward movement in rates lasting a long time to offset the current lower rate on the HELOC vis a vis the first mortgage).

Thoughts?
Let's look at your supposed advantages:

1) The new mortgage rate will be lower, because the bank is transferring 20% of the risk of losing money on your mortgage to you (in the case of increasing interest rates they can pass the risk onto you in the HELOC, but not the fixed rate mortgage). The reduction in interest rate is a true savings, but you have to decide if the risk is worth it. If you aren't actually using the HELOC and rates go up, you would be foregoing these higher rates on whatever funds you cashed in to do this refinance (see 2b below).

2a) The cost of your "guaranteed return" is a loss of $100K in liquidity. The potential for a higher interest rate isn't the only downside to a HELOC. It is also very possible that if the economy tanks OR you lose your job that your line of credit can be cut off. Just when you are most likely to need the money! With a fixed rate mortgage, as long as you make your payments the bank can't get out of the loan.

2b) Too many people buy into the guaranteed savings option without realizing you are comparing apples and oranges. A 30-year fixed rate mortgage will ALWAYS have a higher interest rate than what a bank will pay you on a CD - at the current rates. What people overlook is the opportunity cost. Five years down the road, your mortgage will have the same interest rate - unless you decide to refinance to a lower one. But the 100k you paid against the mortgage probably wouldn't still be earning the same measly rates. My parents had an early 1960s vintage 4.75% VA mortgage loan for the full 30 years. During that period, the mortgage rate was only higher than the rate on a 6-month CD for 3 periods: From the start of the loan in October 1962 until June 1967, from Feb - April 1971, and after Dec 1991. (See the historic rates here). From June 1978 until May 1985 the 6-month CD rate NEVER went below 8%. It peaked at almost 18% in 1981. (No that is not a typo - in 1981, you could get an FDIC insured CD with an interest rate of almost 18%! :shock:) So the supposedly "guaranteed savings" only materialized for less than 8 years out of the 30. And the upside on the CD rates was far, far greater than the downside. My dad always maintained that buying the house and staying put was the best financial decision my parents ever made.

3) The majority of your 3rd "advantage" has nothing to do with refinancing your mortgage, since you are putting the $100K in to reduce the mortgage balance. You could have an equal improvement in cash flow by making a periodic transfer from your CDs or short-term bond funds into your checking account in an amount equal to the reduction in your mortgage payment.

So how much lower is this interest rate? You say "slightly lower" in your first sentence then later say that a higher HELOC rate "would require a significant upward movement in rates lasting a long time to offset the current lower rate on the HELOC vis a vis the first mortgage". You seem to be contradicting yourself in these two sentences.

BOTTOM LINE: While you may not need a 100k emergency fund, the benefits of this proposed plan are a lot less then you think they are.

epilnk
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Re: HELOC as emergency fund - what am I missing?

Post by epilnk » Sat Jan 10, 2015 12:39 am

HELOCs have this bad tendency to go away when they are needed, as many people discovered in 2008. Or be revoked if the bank discovers a job loss or other change in circumstances. Or be canceled for no stated reason ("this bank no longer offer this product however we will wave the fees if you decide to apply for the equivalent but slightly different product that we don't plan to approve you for").

travellight
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Re: HELOC as emergency fund - what am I missing?

Post by travellight » Sat Jan 10, 2015 12:43 am

I do use my HELOC as EF; I have two HELOCs with two different banks just in case one gets yanked.

robertalpert
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Re: HELOC as emergency fund - what am I missing?

Post by robertalpert » Sat Jan 10, 2015 1:05 am

epilnk wrote:HELOCs have this bad tendency to go away when they are needed, as many people discovered in 2008. Or be revoked if the bank discovers a job loss or other change in circumstances. Or be canceled for no stated reason ("this bank no longer offer this product however we will wave the fees if you decide to apply for the equivalent but slightly different product that we don't plan to approve you for").

For the above reasons, its better to have regular credit cards (with zero balance) for use as emergency fund. If the heloc is called in while you still have an employment-related emergency, you would risk the house at the worst possible time.

But keep the Heloc for after the emergency is over --- to pay off the credit cards. Then pay down your Heloc to prepare for the next emergency.

heyyou
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Re: HELOC as emergency fund - what am I missing?

Post by heyyou » Sat Jan 10, 2015 9:30 am

HELOC as emergency fund - what am I missing?
HELOC funds are not immediately payable. The HELOC check is from an out of state address at a bank's home office, so the funding can be delayed for ten days after being deposited, if the check is large. That was my experience with depositing a HELOC check into an account at a different bank than the one that issued the HELOC.

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gasdoc
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Re: HELOC as emergency fund - what am I missing?

Post by gasdoc » Sun Jan 11, 2015 10:59 am

I would keep an emergency fund that consists of funds that are mine- that I don't have to ask for, or wait for. A true emergency fund need is likely to arrive as the result of an interruption in job status, a time when any loan offer may be withdrawn. Also, the habit of depending on debt when life's little obstacles come your way is not a good long term plan.

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papiper
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Re: HELOC as emergency fund - what am I missing?

Post by papiper » Sun Jan 11, 2015 11:32 am

My experience with a HELOC has been very positive. I have no 1st mortgage, but I do have $150,000 line with a variable % HELOC. It currently charges 1.99% and is with my bank I use for checking. Any draw on the HELOC is immediately available in checking the same day. I use it only to bridge short term unexpected needs.

Right now was one of those. I bought a new car because of foreseen needs very recently and wanted to fund ROTH IRA's for myself and my wife on Jan. 1. I could have waited, gotten a an old car, sold stock at short term tax rates, gotten a car loan... lots of options.

Instead I took out $30,000 from my HELOC - used some cash and got the car and funded my ROTH's. In February, the short term stock moves to long term, so I'll sell that and pay the HELOC back to zero.

Cost to me - about $60.

I view the HELOC not as an emergency fund, but a tool to handle short term unexpected cash flow needs to give me time to make effective financial moves with my other assets.

rotorhead
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Re: HELOC as emergency fund - what am I missing?

Post by rotorhead » Sun Jan 11, 2015 9:06 pm

Post by papiper » Sun Jan 11, 2015 12:32 pm

My experience with a HELOC has been very positive.
I view the HELOC not as an emergency fund, but a tool to handle short term unexpected cash flow needs to give me time to make effective financial moves with my other assets.
That's exactly what we do as well. Three years ago had to install new roof, then a year later a new air con system. Used the HELOC to smooth out the cash flow. Works very well at minimal cost.

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