Does home equity equal emergency fund?
Is it really necessary to keep an emergency fund in a savings account if you have a home equity line of credit you could tap instead?
By Walter Updegrave, MONEY Magazine senior editor

NEW YORK ( - I've heard that you should keep three to six months' worth of expenses in a savings account, money-market fund or short-term bonds or CDs in case of an emergency such as loss of a job. But is it really necessary to keep that much money in low-earning assets if you have a home equity line of credit you could tap instead?

-- Tim Rasmussen, Winfield, Illinois

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I'm all for the idea of using a home equity line of credit as a back-up reserve for any number of reasons: cash to cover a large unexpected expense, money to pay for a home improvement or renovation, even a cushion to get you through a period of unemployment.

What makes home equity lines especially suited for such purposes is that their interest rates are usually very attractive (typically the prime rate or a little less) and their repayment terms are more flexible than other loans (often you have the option of paying only interest for the first 10 years or so of the loan).

So I think it makes perfect sense to open up a home equity line of credit when things are going well -- that is, you have a job and your finances are in good shape -- so you can dip into it if you run into run into financial difficulties.

Make it your back-up plan

But I don't think it's wise to make a home equity line your only -- or, for that matter, even your first -- line of defense against economic setbacks.

Why? Well, let's say you lose your job. When that happens, you're quite naturally going to feel some stress when you're faced with having to make mortgage payments and take care of all of life's other ongoing expenses without a paycheck coming in.

If you start meeting those obligations immediately by drawing on your credit line, it seems to me you're creating an additional source of angst: the knowledge that each day you're out of work you're not only losing income, but you're also creating a liability you must meet after you find a new job.

And, in the meantime, of course, you've still got to come up with money to make the interest payments on your home equity line. Yes, depending on the size of your line, you may be able to pay interest by taking out additional draws, but then you could really be digging yourself into a hole that could take a while to claw yourself out of.

That sort of anxiety-producing situation -- no income, loan balance mounting, the interest meter ticking -- could have other serious ramifications, say, forcing you to take a job you'd really prefer not to take or perhaps even relocate in hopes of finding work more quickly.

I'm not saying that paying expenses from your savings will eliminate stress altogether during a bout of unemployment. It's no fun seeing your cash reserve dwindle. But at least you're not piling up debt from day one. If nothing else, you're giving yourself a bigger margin, both financially and emotionally, for dealing with a difficult situation.

Have a healthy emergency reserve first

All of which is to say that I think you should have an emergency reserve that consists of savings in highly liquid assets like money funds, CDs, short-term bond funds or even a savings account, plus the home equity line of credit. And I think you should go to your cash cushion first and turn to the home equity line only after that has been depleted.

That said, if earning a low yield on that cash cushion really bugs you, you might consider keeping your reserve to the lower end of that range of three to six months worth of expenses. The exact level you decide on is largely a matter of how long you feel it might take you to find a suitable job, what other resources you have to fall back on and how uneasy you would feel borrowing to pay day-to-day living expenses.

And, of course, however many months of living expenses you decide to hold in an emergency reserve, you want to get the best return possible on your money -- and the lowest rate on your home equity line of credit. You can search for best rates in your area by going to the Interest Rate section of our site. To compare the latest yields on money-market funds, click here.

Ideally, you won't ever have to dip into either of your reserves, or at least not because of an emergency. But by having access to two rather than just one, you'll be all the better prepared.


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