Should Your HELOC Replace Your Emergency Fund?

There is a school of thought with some financial experts that the age old cash “emergency fund” of 3 to 6 months of income, is a Jurassic concept. The idea is that cash is wasted sitting in low interest bearing savings accounts and a line of credit, be it unsecured or a HELOC, is the smarter way to go.

Let’s break that down the rational there. Let’s say a person earns $3000 a month typically. Times that by 6 months and you have a lump sum of $18,000, which is a fair chunk of change. It would indeed be a shame to have that yielding virtually nothing in interest in a simple savings or chequing account. It would at least be advisable to have these funds in a higher interest bearing, no fee account like those provided by ING.

That being said, the idea of ONLY having a line of credit for back up is troublesome as of late. At the onset of the recent financial crisis, many HELOCs were called, closed or changed in some way at the will of the banks, sometimes with very little notice given to the home owner. The banks decisions to take these actions had little bearing on whether a client had managed the HELOCs well or not, it solely had to do with the riskiness of the product and their need for cash flow.

In some cases, homeowners who were not using the available credit on their lines had them closed by the lender and their emergency funds disappeared just when they may actually require them with unemployment looming. In other instances, rates that had been below prime were suddenly pushed over prime with threat of additional increases. That’s a lot of drama for something that is supposed to provide a level of comfort like an emergency fund.

One possible solution is to invest the funds available on your line of credit. It’s less likely for a lender to close down a line of credit that is maxed out and if the interest rate is reasonable, the spread between what you are buying that money for and what your are earning on it in an investment, may be attractive. You could also have those funds split into various levels of accessibility from a regular savings account right up to a major investment, offering many levels of security for you. Of course, you will be required to make payments on these funds, adding one more payment to your list should you ever be in a position to actually have to use your emergency fund.

The best use of HELOC funds can indeed be investment but I would say it should only be part of an overall financial plan that does more than simply provide back up for a rainy day, such as the plan known as the Smith Manoeuvre.

To my mind, cash is king in this instance and I would avoid using any kind of credit for “back up”. Additionally, the psychological component of building and saving an emergency fund leads to even bigger and better things. Being comfortable having cash laying around that you have free access to, choosing to let it accumulate and grow instead of spending is a trait of the truly financially stable.

Finally, you can’t count a HELOC on your balance sheet as a liquid asset. This can be a huge drawback when trying to obtain financing for just about anything.

Check out this article from Wisebread for a simple way to figure out how big your emergency fund should be.