Using a Home Equity Loan for an Emergency Fund

Most mainstream financial advisors will suggest that you should keep some money aside in a special savings account for emergencies. This seems to make sense, say if there’s something such as a car accident, an unexpected medical expense, or something goes wrong in the house, there’s money to take care of whatever needs to be paid for. This way when an emergency does happen, you don’t have to freak out and wonder where the money comes from.
It certainly makes sense to keep some money in cash reserves so that you have money that you can get to on a short notice should you need to, but doing this comes at a price. This is essentially self insuring your self for emergencies. Like all insurance policies, they come with a cost. Putting money away in a savings account for no other purpose than paying for emergencies might not have a visible cost, but you do have to put it in a rather conservative investment so that you can be sure the money is there when you need it. You don’t want to have your emergency fund in mutual funds only for you to have an emergency when the stock market happens to be down! Generally people will put their emergency funds in basic savings account earning 4% or 5% interest.

A lot of people who consider themselves financially savvy think that putting money away in a basic savings account has too much of an opportunity cost for that to make financial sense. They would rather invest that money in something that will have a bit more risk but come with a much better rate of return over a long period of time. Of course they still need some cash available should an emergency happen, so many people get what are called a home equity lines of credit.

Essentially a home equity loan or a home equity line of credit is a revolving loan similar to a credit card. The difference is that your home equity line of credit is a secured loan, it’s a second mortgage. This is why you can get much better interest rates on home equity loans compared to credit cards. If the borrower happens to not pay, the bank can foreclose on the person’s home and recoup their cost.

Is using a home equity loan as an emergency fund a viable alternative to putting money away in a plain old savings account? The answer to that is no. When you are having financial problems, the last thing that you need is another payment and more debt to worry about. Usually the problem is too much debt, and adding more won’t solve the problem.

Usually it doesn’t even make financial sense to invest your money in a mutual fund and then borrow on a home equity loan when an emergency happens. After you pay taxes and pay the interest on a home equity loan, you’re not making that much more money. When you factor in risk for all of the added debt you’re taking on, it’s not worth it at all.

There’s also the damage to your credit score. When you borrow more money, your debt to income ratio increases, as well as your credit utilization, which will be very detrimental to your credit score should you need to be taking out some sort of major loan in the near future.

Using a home equity loans or home equity lines of credit is just not a good alternative to saving money in a high-yield online savings account for an emergency fund. Save money for emergencies, but don’t try to play games with debt to try to get a little better deal. An emergency fund is insurance, not an investment.