Playing down the odds of a financial crisis is like tempting fate. Financial adversity can strike when we least expect it. If it does, and you can't make ends meet, having a backup fund can keep you afloat.
Common wisdom suggests squirrelling away three months of living expenses in an emergency fund, like a tax-free savings account. The problem is, safety and liquidity come with a price – dismal returns.
Today's insured savings accounts pay just 1.9 per cent or less. That sort of gain doesn't thrill many people. So, many folks use home equity lines of credit (HELOCs) as emergency fund substitutes.
HELOCs are available to homeowners with at least 20 per cent equity and good qualifications (provable steady income, a reasonable debt ratio, a solid credit score, a marketable property, and so on).
If you qualify, you can find HELOCs today at 3.50 per cent interest. (You don't pay interest unless you borrow from them, of course.)
HELOCs offer one potential benefit versus a plain-Jane contingency fund. They provide a backup funding source if times go bad. That lets you invest your TFSA money in higher returning (and presumably higher risk) assets. Instead of a 2-per-cent return in "high-interest" savings (a paltry yield that barely keeps pace with inflation), it may be possible to earn 5 per cent or more in diversified dividend-paying mutual funds.
Currently, only 17 per cent of Canadian households have a HELOC, suggest data from the Canadian Association of Accredited Mortgage Professionals. This number could eventually rise if more people start using HELOCs as backups and move their languishing cash to higher-yielding investments.
But turning a HELOC into a safety net doesn't make sense for everyone.
When to use a HELOC rather than an emergency fund:
- You’re risk tolerant and have a long time horizon until retirement, and/or
- You want to funnel all available cash toward paying off higher-interest debt, and/or
- You want to use your cash to make a mortgage repayment (assuming the rate is sufficiently higher than your TFSA), and
- You have a stable job and other investments that you can tap in a worst-case scenario.
When not to use a HELOC in place of an emergency fund:
- You’re an undisciplined saver and prone to overspending with credit, and/or
- The odds of your having an “emergency” are high, and/or
- You don’t have perfect credit, or
- You don’t have a stable job, or
- You’d likely hold the balance for an extended period, or
- You’d likely have trouble making the minimum HELOC payment.
In this latter case, missed HELOC payments could lead to foreclosure and put you out on the street. Albeit, you might be able to borrow from the HELOC to make your HELOC payments (a bad situation made worse).
There's also another risk with a HELOC. If a lender cuts back on your credit line, your emergency resource could disappear. A lender might do that, for example, if you've racked up credit and keep making only minimum repayments, or if a lender determines that your home value has plunged.
Many of these risks are low probability events. But if you truly want 100 per cent assurance in an emergency, "rely on your cash, not a HELOC," says money manager Adrian Mastracci of KCM Wealth Management. "To me, it's more important to take care of emergencies, not the investing."
That said, Mr. Mastracci offers an alternative for long-term investors who are financially stable, risk-tolerant and creditworthy: Get a risk-free TFSA for emergencies, and borrow from a HELOC (or mortgage if preferable) to invest in unregistered investments yielding 5 per cent or more. This strategy assumes the loan interest is tax deductible.
If you do sign up for a new HELOC, try to find a lender that waives the setup (legal and appraisal) cost. They're out there. Just keep in mind you'll often pay those fees if you later switch your HELOC to another lender, whereas you typically don't when transferring a regular mortgage.
When all is said and done, certain people simply prefer a cash rainy-day fund to a HELOC. It makes them feel more financially sound. And that's perfectly fine when we're talking about the equivalent of just three months of expenses. Sometimes financial decisions are about more than risk and return.
Robert McLister is the editor of CanadianMortgageTrends.com and a mortgage planner at Verico IntelliMortgage, a mortgage brokerage. You can also follow him on twitter at @CdnMortgageNews