Home equity can help prepare for emergencies

Home equity line of credit should not be the entire plan

We have written before about how a home equity line of credit, also known as a HELOC, can be a great source of funds for emergencies. You never know when you may need some ready cash, and a line of credit, unlike a home equity loan, does not require that you take the cash upfront. Furthermore, the line of credit has more flexible repayment terms. Repaying a home equity loan is more like repaying a mortgage while repaying a line of credit is more like paying on a credit card.

So if you have a sudden $2000 car repair, or have some damage to your home that is not covered by your homeowner insurance, a line of credit can be a lifesaver. The same is true if you lose your job; you can have cash available if you need it. But for reasons we will outline below, the line of credit should be just part of an overall emergency plan. It should not be the entire plan.

First of all, you will need to apply for the line of credit when times are good. You cannot, for instance, reasonably expect to borrow against your home when you are out of work. It is best to take out the line of credit before you need it and to just forget about it until you need it. But you still need to save cash for that rainy day, too.

An old line of reasoning suggests that having a three to six month reserve of cash at all times would be a good “nest egg” for emergencies. The presence of a lot of equity in your house should not change that. Cash is the best thing to have when something goes wrong, such as a loss of a job. You can certainly get cash from a line of credit on an as-needed basis, but it’s not really cash. It is a loan, and a loan needs to be repaid. That being the case, a line of credit may be a good stopgap solution to a problem, but ultimately, you will need to pay the money back. That’s a problem if your emergency is a unemployment of unknown duration. How long will you be out of work? The money needs to eventually be repaid, whether you are working or not.

Ideally, you will plan for emergencies by establishing the following plan:

• Take out a home equity line of credit while you are employed and do not need to use the money for anything.
• Save some money in long-term investments, such as stocks or bonds, through a mutual fund or a 401(K) fund.
• Put some cash in a savings account that is readily accessible when you need it in a pinch.

The home equity line of credit is a great tool for use when something unexpected goes wrong and you need to get some cash in an emergency. But the old suggestion that you shouldn’t put all of your eggs in one basket applies here. A line of credit is just one tool in your financial toolbox. Use it wisely.