The Fallacy of Using a HELOC as an Emergency Fund

August 5, 2008 by  
Filed under Debt and Credit

Is a home equity line of credit (HELOC) suitable as an emergency fund as many suggest?  Some of today’s news confirms my belief that it clearly is not suitable.  Let’s discuss, shall we …..

Most financial planners and responsible wage earners understand the importance of having an emergency fund in place.  The typical recommendation is that the emergency fund be large enough to fund three to six months of non-discretionary expenses.  This protects against a money crisis brought on by illness, job loss, uninsured casualty loss, and the like.   Without an emergency fund in place, such a financial disaster could lead to massive increases in high interest credit card debt, foreclosure, or even bankruptcy.  So far, so good.

The problem is that some financial planners and many high risk consumers believe that having a HELOC in place will provide a safety cushion to the homeowner such that having an actual cash reserve as an emergency fund is unnecessary.  This is bad financial planning advice and bad consumer thinking.

Bloomberg today reported that Morgan Stanley (#2 U.S. securities firm) had informed several thousand of its HELOC customers that it was freezing their HELOC lines, i.e., the customers would be unable to draw against the HELOC for any purpose.  We can all probably guess why this happened.  Morgan Stanley began auditing its HELOC portfolio.  This audit no doubt confirmed that due to depressed housing valuations,  many of its HELOC customers had insufficient equity in their homes to provide adequate collateral for the HELOC (at least in the eyes of Morgan Stanley).   For some of these customers, no HELOC = no emergency fund.

Now some readers are thinking that this could not happen to them.  They believe that because they have more than minimal equity in their homes, there is no chance that their HELOC will be frozen.  Really?  Don’t you think that Morgan Stanley’s customers thought the same way?  Do you even know the terms applicable to your HELOC under which it can be frozen?  In today’s credit markets, loan underwriting criteria are changing rapidly and not in favor of the borrower.  A lender with a large portfolio of flexible credit lines in play is going to take action to protect itself.  If that means the end of HELOC flexibility, well too bad for the customer.

The bottom line is that a HELOC is not a true emergency fund because the HELOC can be taken away by the lender if and when it feels insecure.  Most HELOCS permit this and the borrower has little or no control over it. 

In a financial emergency, true liquid cash is king.

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  1. […] on their loan balances.  There is no more using your home as an ATM machine.   Some lenders have frozen HELOCS altogether because of falling real estate values.  What is worse, suburban real estate values may […]

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