A SayEducate.com article recently suggested given that the current state of the economy will mostly likely worsen, homeowners should think about opening up a home equity line of credit. The suggestion includes the following arguments:
1. If you are currently employed, a home equity line of credit will be more easily secured versus when you are out of work. And if you do lose your job you can use the credit to pay for emergencies.
2. Rates are currently low, therefore it makes sense to obtain credit now.
3. Whether you use your credit or not you have the option to tap available funds.
My view couldn’t be more opposed to the arguments above. First, if you do not need to use credit then there is no reason to apply for a home equity loan. Most individuals do not realize that while you can borrow against your home to purchase a car, make home improvements, etc., one still builds up debt. In turn, a home equity line of credit is NOT free money.
Instead, I would advise individuals to build a true emergency cash fund that can handle 1., home, car, and any other expenditures outside normally budgeted items and 2. allow you to ride out a large gap of unemployment (say between 6-9 months). In my very basic view, if you do not have the cash at hand to make a large expenditure then you haven’t done your homework and prepared for life’s inevitable emergencies. And, furthermore, a home equity line of credit is simply a means of increasing debt, it’s not a solution to the times in one’s life when a large amount of cash is needed.
In sum, forgo the home equity lone of credit game and bite the bullet and build up your cash reserves!
I’ve gotta disagree with you. Depending on the terms, a HELOC which you never tap can actually be a much better deal than having emergency cash. Let’s do the math.
Say you have a $40k emergency fund and have enough credit rating and home equity to qualify for a $40k HELOC. You can either a) keep the emergency fund in a safe (FDIC insured), liquid (accessible at a moment’s notice) savings account earning maybe 3% interest. Your other option is to get the HELOC and use the $40k to pay down your mortgage. Unless your mortgage rate (probably above 4.5%) is less than 3% (your savings rate), you’re better off paying down the mortgage. You also still have the emergency cushion of $40k in the form of a safe, liquid HELOC.
Now, if an emergency comes along, you can draw on the $40k HELOC. The only downside now is that you’re paying interest on that money. But wait! You would have been paying interest on it anyway if you had the emergency fund – it’s just that you would have been paying interest through your mortgage.
The risk comes if you don’t have the discipline to keep your hands off the HELOC in a non-emergency situation. Of course, if you don’t have the self-control to keep from drawing on your HELOC, you probably don’t have the self-control to keep from drawing on a $40k emergency fund.
Rick,
I see your strategy and it’s certainly viable. There are 2 big issues that come up that I can think of:
1. I would be curious to see how many people take out HELOCs to use “only as emergencies”, yet end up using them for other purposes. My guess is probably far too many to justify recommending to others on a broad level to use the HELOC strategy. We all claim to be the exception to the rule, right?
2. Even if you pay down $40k on your mortgage, and draw off of a HELOC in times of distress, you have your mortgage payment, and guess what? If I’m not mistaken, you just picked up a separate monthly payment for your HELOC too. So just when times get tight, you’ve added an additional monthly bill to your plate. This seems counter-intuitive to an emergency situation.
Again, great comment, and if this was a straight math issue, I’d probably agree with you. But since personal behavior, risk, and add’l payments enter into the equation, I’d say a liquid emergency fund is probably the better route.
Nice article, Scordo!
Jason,
I understand your point about people dipping into the HELOC for non-emergency uses, but then, doesn’t the same danger apply to an emergency fund?
Also, yes, you do have an extra payment if you draw on the HELOC, but of course, your drawing on the HELOC during that period, so it’s really a wash. Just draw an additional amount to cover the HELOC payment.
Btw, I am in favor of having both an emergency fund and a HELOC, mainly b/c I would be loathe to draw on a HELOC during even an emergency. That’s how behavior fits into the equation for me, at least.
Most homeowners now have a distrust of HELOC’s but a trend I have seen is to refinance at a lower interest rate for a 30 year fixed.
Yes, you might free up a little monthly cash but now you have saddled yourself with mortgage payments usually well past retirement age. You could be paying a mortgage on a house for 40 or more years. Most people that refinance don’t have the cash so they roll costs into the mortgage. I wish people would stop falling for these gimmicks.
As far as 40k savings, are you talking about real savings? As in I put cash into an account or are you really just talking about assests that just might not be there right now?
Hi Rick,
I see your argument, but need to side with Jason. My logic is grounded in not picking up debt and a HELOC is pure credit. If one is looking to pay down a mortgage, per your example, then they can take the 40K in cash reserves and put 20K towards a prepayment and the other have can remain in a high interest money market account.
Jason / Rick, great points!
Vince
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I have a related question.
I have never bought a house before, so I’m really not savvy about mortgages or HELOC’s. However, my boyfriend and I are good savers. We have enough money to liquidate our stocks/mutual funds and pay all cash for a house and still have enough cushion for maybe a year’s worth of expenses. However, my boyfriend prefers to keep even more assets on hand than that. So we are planning to get a mortgage to pay for part of the home price. Right now we can get a mortgage for about 5.25% interest, and of course there will be fees etc for setting up the loan.
My question is … would it be better for us to get the conventional loan on the mortgage when we buy the house, or would it be better for us to pay ALL CASH for the house and then get an equity line of credit for whatever amount that my boyfriend wants to have on hand for emergencies, etc? Right now Charles Schwab is offering an equity line of credit with no lender’s fees and an interest rate of 3.99%.
Is it possible to get a 30-year fixed rate with regular monthly payments on the HELOC, something like what we would have on a regular mortgage? If so, it sounds like it would make more sense to get the HELOC for 3.99% instead of the regular mortgage for 5.25%. But if the HELOC interest rate is something varies all over the place, then it’s probably a safer bet to go with the regular mortgage that we know will be only 5.25% for the next 30 years.
What do you think?
THANKS!
Anne in San Francisco
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Hi Anne,
Thanks for the comment. Answer is here: http://www.scordo.com/2009/08/reader-mailbag-scordo-questions-heloc-mortgage-lower-rate.html
Vince
Better to have it and not need it than need it and not have it.
Thanks for sharing a good article and tips on line of credit
It’s really the same thing as your cash savings, all an equity line of credit does is provide liquidity to your asset of your property which has no liquidity unless you sell it, which takes much longer. So it let’s you access the money (CASH) that you have already saved up in the home at any time and without having to find a buyer, lose the asset or pay any selling costs.
If you want to save cash, you might as well put it on the mortgage it is still saving cash either way. You haven’t increased debt, you’ve reduced the equity that would be realized on the sale of the property, which can have tax advantages if you rent it out.