Having access to cash in case of emergencies is one of the cornerstones of personal finance. That’s because a robust emergency fund can protect your budget and income when an unexpected expense strikes. But what is an emergency fund supposed to consist of – and what if there’s not enough money in your fund when you need it?
A home equity line of credit (HELOC) can serve as a strategic backup plan for your emergency fund. Typically, these flexible lines of credit have interest rates currently hovering around 7.2% – and you only borrow money if and when you need it.
Here’s what you need to know about using a HELOC as your secondary emergency fund:
Key Takeaways:
- Experts recommend having an emergency fund equal to 3 to 6 months’ worth of living expenses, in case of income loss.
- A home equity line of credit (HELOC) allows a homeowner to borrow against their equity through a revolving line of credit.
- Homeowners may borrow from a HELOC, pay it back, and borrow again during the draw period, which typically lasts 10 years.
- If you use a HELOC as a secondary emergency fund, it’s best not to draw money except in emergency situations.
What Is An Emergency Fund?
An emergency fund is a dedicated savings account or other cash reserve that you set aside for unplanned or emergency expenses. These unexpected expenses might include anything from a leaking roof to a root canal to a temporary income loss.
Without an emergency fund, these kinds of unexpected expenditures can wreak havoc on your regular budget, making it difficult to stay on top of your normal monthly bills. By building an emergency fund, you ensure that you can handle the cost of an unplanned expense without affecting any of your other financial obligations.
How Much Should An Emergency Fund Be?
Financial experts typically recommend building an emergency fund that’s equal to 3 to 6 months’ worth of living expenses. With a savings cushion that size, you can survive a job loss of 12 to 24 weeks, longer than the roughly 11 weeks that’s the median amount of time Americans spend unemployed after a layoff, according to the Bureau of Labor Statistics.
Setting aside the equivalent of 6 months’ worth of living expenses can be a slow and daunting process, however – especially if you’re starting from scratch. New homeowners who have just seen all their savings go toward a down payment and closing costs may feel disheartened at the idea of trying to save so much.
It can be helpful to set a smaller goal to begin with – such as a $1,000 emergency fund. Setting aside that much can be a much more manageable savings goal that still offers you some protection from unexpected expenses, even if it can’t cover an extended loss of income.
Then, once you’re working on building your emergency savings past the $1,000 mark, you might consider opening a home equity line of credit (HELOC) at the same time. The HELOC could be a potential secondary emergency fund if you need access to more money than you’ve put in your savings account.
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What Is A Home Equity Line Of Credit (HELOC)?
Like a home equity loan, a HELOC allows a homeowner to borrow against the equity in their home through a bank, credit union or other financial institution. The big difference between the two is that the money from a home equity loan is disbursed in a single lump sum at closing, while a HELOC is a revolving line of credit, which works a little like a credit card.
To qualify for a HELOC, homeowners will typically need to meet the following eligibility criteria:
- At least 15% – 20% equity in the home
- A good credit score, ideally above 700
- A history of on-time payments
- Reliable income
- A low debt-to-income ratio
- Proof of homeowners insurance
Note that eligibility criteria vary by lender, so it’s worth comparing multiple options before you apply.
How Much Can You Borrow With A HELOC?
A HELOC is a revolving line of credit, similar to a credit card. You can access money from it when you choose and only borrow what you need.
Your lender sets your HELOC credit limit by multiplying your home’s value by the lender’s loan-to-value ratio (LTV), which is commonly set at 80%. This calculation determines your maximum borrowable equity.
Home Value x LTV = Maximum Borrowable Equity
From there, the lender subtracts what you currently owe on your mortgage from the maximum borrowable equity to determine your HELOC credit limit.
Maximum Borrowable Equity – Amount You Owe On Mortgage = HELOC Credit Limit
For example, if your home is worth $410,000, and you still owe $307,000 on your mortgage, here’s what your HELOC credit limit would be:
$410,000 x 80% = $328,000
$328,000 – $307,000 = $21,000
In this situation, you could get a HELOC with a credit limit of up to $21,000.
How Does A HELOC Work?
There are two phases to a HELOC: a draw period and a repayment period. The draw period is the time frame when your line of credit is available for you to use, up to your limit, at any time.
You may borrow money from your HELOC, pay it back, and borrow again as many times as you like during the draw period. Alternatively, you can also choose to make interest-only payments during the draw period.
Once the draw period ends (typically after 10 years), you can no longer borrow money from your HELOC. At that point you have entered the repayment period, and you will have to make full monthly payments to cover the principal and interest over a period of 10 to 20 years.
HELOCs usually have variable interest rates, which means your rate may fluctuate over time – although some lenders will allow homeowners to switch to a fixed interest rate once they have reached the repayment period.
Additionally, your lender may also charge fees for taking out the HELOC, require a minimum withdrawal amount when you borrow from it or set minimum monthly payments during the draw period when you carry a balance.
Common Fees For HELOCs
Before you choose a lender for a HELOC, be sure to confirm any closing costs or fees, which can add 3 – 6% to your total, depending on the lender.
There are several types of fees that can be associated with a HELOC, although each lender may choose different ones to apply or waive. If you are considering taking out a HELOC to use as a secondary emergency fund, you should be prepared for the possibility of these types of fees or costs:
- Application fee: In many cases, borrowers must pay an application fee to the lender simply to apply for a HELOC. You may not receive this fee back if you are turned down for the loan.
- Home appraisal fee: The formal estimate of the value of your home, prepared by a professional appraiser, may be something your lender asks you to pay for.
- Closing costs: Thesemay include fees for property and title insurance, attorneys, title search, mortgage preparation and filing, and taxes.
- Annual fee: Similar to some credit cards, many HELOCs charge an annual fee.
- Early closure fee: If you close your HELOC prior to the original maturity date, your lender may charge you a fee.
- Inactivity fee: Some lenders charge borrowers a fee for not taking money out during the draw period.
- Fixed-rate lock fee: You will generally have to pay a fee for switching your HELOC to a fixed-rate loan at the end of the draw period.
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How Can I Use A HELOC As A Strategic Emergency Fund?
Using a HELOC as a strategic emergency fund requires some careful advance planning. That’s because you will need to have a HELOC in place before you begin the draw period. That process involves finding the right lender, gathering documentation and applying, getting an appraisal of your home and closing on the loan. If you are interested in using a HELOC for secondary emergency funding, it pays to get the line of credit in place well before you may need it. Closing on a HELOC typically takes 2 – 6 weeks.
But once you have your HELOC in place, it can help you pay for a major financial crisis that your savings might not be able to cover. You’ll pay a lower interest rate than if you were forced to pay for your emergency expense with a credit card, and depending on how much equity you have built in your home, you may well have a higher credit limit with a HELOC than you would on a credit card.
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What Are The Potential Pitfalls Of Using A HELOC As An Emergency Fund?
If you’re using HELOC as a financial safety net, it’s best to treat it like an “in case of emergency” account – and otherwise leave it alone. That’s because there are some serious downsides to a HELOC that could cause problems if you’re not careful.
For starters, it may be a mistake to make your HELOC a dual-purpose emergency fund/renovation fund. While there is nothing wrong with paying for a home refresh with a HELOC, using one for both your renovations and an emergency fund could quickly get you in over your head. Imagine if an emergency strikes in the middle of your kitchen demolition right after you’ve maxed out your HELOC.
It’s also important to remember that a HELOC uses your home as collateral. If you default on your HELOC payments, you could lose your home. That means anyone who struggles to keep their hands off a ready source of credit may not be a good fit for a HELOC.
In addition, like many loan products, a HELOC’s fees could negatively affect your budget.
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Who Should Use A HELOC As A Backup Emergency Fund?
To qualify for a HELOC, you should have a good credit score (at least 700) plus at least 15% – 20% equity in your home. But that’s not all you should consider if you want to use a HELOC as a secondary emergency fund, since it could instead become a second source of debt if you’re not careful.
You should also have a stable income, an existing emergency fund of at least $1,000 that you consistently contribute to, and enough room and flexibility in your budget to afford any up-front and ongoing fees for your HELOC.
Lastly, it’s important to keep the mindset that this HELOC is for emergencies only..
If all of this doesn’t describe your situation, then using a HELOC for an emergency fund may not be the right strategy for you.
The Bottom Line: A HELOC Can Act As A Secondary Emergency Fund
Establishing a HELOC as a secondary emergency fund can offer your family financial flexibility. While you are actively building a traditional emergency fund through regular contributions to a savings account, your HELOC can be available as a financial safety net in case of larger emergency expenses.
Ben Shapiro
Ben Shapiro is an award-winning financial analyst with nearly a decade of experience working in corporate finance in big banks, small-to-medium-size businesses, and mortgage finance. His expertise includes strategic application of macroeconomic analysis, financial data analysis, financial forecasting and strategic scenario planning. For the past four years, he has focused on the mortgage industry, applying economics to forecasting and strategic decision-making at Quicken Loans. Ben earned a bachelor’s degree in business with a minor in economics from California State University, Northridge, graduating cum laude and with honors. He also served as an officer in an allied military for five years, responsible for the welfare of 300 soldiers and eight direct reports before age 25.
