In this episode of ThimbleberryU, we dive into a critical financial planning misconception: using a HELOC (home equity line of credit) as a cash reserve. This approach can increase financial risk and reduce flexibility, and we offer smarter alternatives for financial security.
Amy begins by explaining what a HELOC is—a line of credit secured by the equity in your home that operates much like a credit card, but with a variable interest rate and lender-imposed limitations. Unlike cash in the bank, which is liquid and entirely within your control, a HELOC is borrowed money subject to lender discretion. Amy recalls the 2008 financial crisis when many lenders reduced or froze HELOCs due to economic downturns. If a HELOC were someone's sole cash reserve, they might find themselves without access to funds when they need them most.
There's also the unpredictable nature of HELOCs. Factors like interest rate variability, declining home values, or personal credit score changes can make repayment more expensive or render the HELOC inaccessible. Relying on this type of borrowing creates new debt, adds to monthly financial burdens, and can even endanger your home if you're unable to make payments.
Amy emphasizes the importance of building a liquid cash reserve as the cornerstone of financial planning. She advises saving three to six months' worth of living expenses in a savings or money market account. This cash reserve acts as a financial "life jacket," offering immediate access to funds during emergencies without incurring debt or lender restrictions.
While a HELOC should not serve as a cash reserve, Amy acknowledges it can have a place in a financial plan. For example, it can be a useful tool for home improvement projects, provided it is used strategically and repaid responsibly. A cash reserve is like a life jacket and a HELOC is like a paddle—both valuable, but with distinct purposes.
You should approach emergency funds with a clear purpose. Start small, save consistently, and remember that a solid cash reserve is the foundation of financial stability. A HELOC, while useful in certain scenarios, is not a replacement for cash.
ThimbleberryU 127 - Why a HELOC is NOT a Cash Reserve
Speakers: Jon Gay & Amy Walls
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Jon Gay (00:08):
Welcome back to ThimbleberryU. I'm Jon Jag Gay, Amy Walls from Thimbleberry Financial joins me as always. Great to be with you, Amy.
Amy Walls (00:14):
Jag, great to talk to you.
Jon Gay (00:16):
I love how you have a knack for explaining things so well, which is why I'm really excited about today's topic. It's a really common misconception that you're going to dispel for us, and that is about HELOCs – that stands for home equity line of credit - if our listeners aren't aware.
And I think a lot of listeners think of it as kind of a cash reserve, they dip into it when they need to, when they don't need to, and I think you are going to set the record straight for us today.
Amy Walls (00:41):
I'm going to try. I like this topic too. I think it's important because a lot of people think that a HELOC can double as a cash reserve, and obviously, it can, but is it a smart idea? That's the real question.
And while it sounds convenient, using it as a cash reserve actually increases risk in someone's financial situation and reduces financial flexibility. So, I think that's the focus of what we're going to talk about today.
Jon Gay (01:07):
I can see on the flexibility part, because you'd have funds tied up that way, but let's start with the basics. Explain what a HELOC is, and why it is not the same as having cash in the bank, Amy.
Amy Walls (01:18):
Yeah, a HELOC (home equity line of credit, as you shared) is a mortgage. But it's different than your traditional fixed mortgage. It's a line of credit like a credit card that's secured to your home. So, it's using your home equity as collateral against your balance. You borrow what you need, you repay it, and you can borrow again up to your credit limit.
The difference between it and a credit card, if you will, outside of it being tied to your home, is that there may also, more than likely, there is a draw period. Like you can draw off of this for 10 years and it has to be a hundred percent paid back in 20 years, something to that effect.
Now, one question that listeners may be asking is, what's the difference between a HELOC now and cash? I use my credit card like cash.
Jon Gay (02:14):
We've talked about the difference between HELOC and a credit card – now, HELOC versus cash. Okay.
Amy Walls (02:18):
Yep. So, cash in the bank, your cash that you have in the bank, just like cash you might have buried in the backyard, is liquid and it's yours. There are no strings attached. But a HELOC is borrowed money, and it does depend on the lender's terms and conditions.
So, imagine this, Jag. You have a medical emergency, and with cash, you can pay for that immediately. Imagine though that you don't have cash, and with a HELOC, you have to borrow the money to pay the significant medical bill. That could take time or it could add stress.
There's also one more risk, and I'm going to point back to 2008 with this, where this happened really consistently. People had home equity lines of credit- I actually had one, and the lender looked and said, “Risk is too high, we're shrinking or canceling all the lines in all future purchases.” And this wasn't because they were necessarily looking at individuals.
In our case, it just happened to be the lender, which is a well-known bank said, “Nope, not doing this anymore. Done, continue to pay it off, but you can't borrow anymore.” So, had that been my cash reserve, that cash reserve was cut off with no warning.
Luckily, it wasn't my cash reserve. But that is a really strong reason that we don't want to do that because in a down market, in a down economy, that's when lenders are going to look at doing that, and it's probably the time that people don't have a cash reserve.
Jon Gay (04:04):
I just want to make sure I understand this point, and I'm going to use sample numbers here, and these weren't your specific numbers of course. But you have a home equity line of credit for say, $20,000 and then the bank says, “You know what, times are tough.”
Times certainly were tougher banks in 2008, as you referenced: “I think we're going to shrink this and only let you have $10,000 instead of $20,000, and you've already taken $9,000, so you only have that a thousand left and we're going to ask you to start paying that back now.” Do I have that right?
Amy Walls (04:30):
Essentially, yes. Depending on the lender, the details vary, but the general gist of what you just said is exactly the reason.
Jon Gay (04:38):
And this gets into the risks of relying on a HELOC as an emergency fund just like we talked about. And this could happen when you need the money the most.
Amy Walls (04:45):
To maybe say it more simply than what we were just talking about, it's lender control versus your control. Lenders can freeze or reduce lines of credit, as we just talked about during that economic downturn. Financial changes are one of the risks. They're also going to look at credit scores. So, if you lose your job and your credit score drops, there's a chance that you may not qualify to use that HELOC.
Jon Gay (05:10):
Oh, okay.
Amy Walls (05:11):
So, just because you've gotten it, it is not a guaranteed thing into the future.
Jon Gay (05:16):
Got it. Okay.
Amy Walls (05:18):
So, kind of alluding to that scenario we talked about earlier, but to be more specific, you lose your job during a recession and plan to use the HELOC to pay for your expenses, and you go to borrow against it, you'd find that your credit limit was reduced or frozen.
And that could also be not only because of your credit, but because of declining home values, and that's a really scary situation. So, we want cash reserves because they're the foundation of a financial plan to be within your control.
Jon Gay (05:50):
Got it. Okay. Let me ask you this specific question, Amy. Some people think a HELOC is cheaper than some of the other alternatives we've been talking about, because you only pay the interest when you borrow. What's the downside here?
Amy Walls (06:03):
Yeah, and I don't want to sound like a broken record. The downside is unpredictability, all the things we've already talked about that I won't repeat. Additionally, variable interest rates. So, with a mortgage, you get a fixed interest rate. With a HELOC, your interest rate varies.
So, as interest rates go up, that means the interest rate on your HELOC will go up. So, the costs, the amount you're paying per month can rise quickly making that repayment more expensive than you budgeted for or expected.
Jon Gay (06:38):
We're recording this on December 11th of 2024, and we've seen interest rates bounce around a lot in the last year plus.
Amy Walls (06:45):
Absolutely. The other thing is the amount of debt you're carrying or debt burden. Using a home equity line of credit for emergencies creates new debt obviously, and that's going to add monthly payments to your budget.
So, if we look at debt to income ratio, which especially with buying new houses and things is important, this is a way that you don't necessarily think about. “Oh yeah, I've just increased that debt burden significantly.”
Jon Gay (07:13):
Got it. Okay. So, those are kind of short-term implications, Amy, but what about long-term implications? How could relying on a HELOC as an emergency fund affect someone's financial flexibility or security longer term?
Amy Walls (07:25):
Great question. Really, it limits options and increases risk. So, to be more specific, you can have restricted borrowing. We've alluded to some ways that can happen already. But a really simple example, if your HELOC is maxed out, maybe you do a major home remodel for that HELOC, that's a reasonable reason to have a HELOC.
It's maxed out, you use all your cash also, all your extra cash, your emergency fund during this remodel because there were cost overrides. So, no cash, HELOC is maxed out, and you experience an emergency, it's now not available for those other needs.
You also have risk to your home, and I think people forget about this. A HELOC is secured by your house, as we already talked about. So, let's say you have a medical emergency and no one's making your payments for a couple months while you're comatose, that could lead to foreclosure.
Jon Gay (08:24):
That’s scary.
Amy Walls (08:25):
Absolutely.
Jon Gay (08:27):
So, you have made a very strong point here of why HELOCs should not be used as an emergency fund, as a credit card, things like that. So, alternatives, before we wrap up, Amy – if a HELOC isn't a good option, what are better strategies for building a reliable cash reserve? And is there ever a place for a HELOC in someone's financial plan? You're going to say it depends. (Laughter)
Amy Walls (08:48):
Well, let's see if I can avoid that. So, here's what works better than a HELOC – having actual cash and accepting the A is A, and A is not C. So, save cash-
Jon Gay (09:01):
I was not told there'd be algebra in today's podcast.
Amy Walls (09:04):
Save cash, just do it, don't fight it. Have three to six months of your living expenses set aside in a bank account savings or money market account that is liquid, safe, FDIC insured, and always accessible.
Jon Gay (09:21):
I like it.
Amy Walls (09:22):
When you do have a HELOC, so to your second question, is there ever a place for a HELOC in someone's financial plan? Yes. We are about to do a major basement remodel rather than use cash or investments, we are using a HELOC for it.
So, having that accessible to pay for those costs, knowing we can pay it back, knowing the rate will fluctuate, is a very reasonable way to meet and improve your home. It is not, however, a cash reserve. So, does it fit in a plan as a cash reserve? I don't believe it does. Is there a place for it in a financial plan other than a cash reserve? Absolutely.
Jon Gay (10:05):
Okay. That makes a lot of sense.
Amy Walls (10:07):
Think of it this way Jag, your cash reserve is like a life jacket. It keeps you afloat when emergencies and even opportunities hit. A HELOC is more like a paddle, it can help and it's necessary perhaps to make the boat go. I mean, there's other ways you can make the boat move without the paddle, but it's not your primary safety tool.
Jon Gay (10:30):
And if you only have one side of that paddle, you're just going to go in circles. I don't know if that was too far on that analogy, but I went for it.
Amy Walls (10:38):
Maybe you switch sides as you paddle.
Jon Gay (10:40):
Okay, good answer. Alright, as we wrap this up, Amy, and it has been really helpful today to get some clarification on this: what are your biggest pieces of advice for someone rethinking their emergency fund strategy?
Amy Walls (10:53):
The most important thing with emergency funds is that one, you remember its purpose. It is the foundation of every other financial thing you do. And having a cash reserve as the foundation should give you peace of mind. There are very few of us that would buy a house that we intend to live in and not tear down that has a poor foundation.
Jon Gay (11:21):
I like that.
Amy Walls (11:22):
And so, this is the same thing. Build your cash reserve, start small if you need to. Make it a habit to constantly contribute to that even when you've already met it. Because at some point, there will be emergencies and opportunities that will cause that to get spent down a bit and you have to have a way to replenish it.
And once you've built that foundation, then a home equity line of credit can be a great backup that you use for other opportunities in your life, but not where you're really planning for it to be a cash reserve.
Jon Gay (11:59):
One tool in a toolbox with a very specific use. I like the way you wrap that up Amy, because we've talked about the psychology of money so much in this podcast and people want to save money, people want to grow money. I want money, I want to have money – “Well, why do you want that money? What's your purpose for the money?”
So, I'm glad you tied it all back together with the emergency fund at the end there; know why you have the emergency fund, know why you would use a HELOC if you wanted to use a HELOC.
Amy, if somebody has questions about their finances in general or about the specific stuff we talked about today, how do they best reach you and your team at Thimbleberry Financial?
Amy Walls (12:29):
They can give us a call at (503) 610-6510 or find us online at thimbleberryfinancial.com.
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Jon Gay (12:38):
Great stuff, Amy. We'll talk again in a couple weeks.
Amy Walls (12:40):
Sounds great, Jag.
Jon Gay (12:42):
Securities offered through registered representatives of Cambridge Investment Research Inc, a broker dealer, member of FINRA/SIPC. Advisory services through Cambridge Investment Research Advisors Inc, a registered investment advisor. Cambridge and Thimbleberry Financial are not affiliated.
Discussions in this show should not be construed as specific recommendations or investment advice. Always consult with your investment professional before making important investment decisions.
Securities offered through registered representatives of Cambridge Investment Research Inc, a broker, dealer member FINRA/SIPC. Advisory services through Cambridge Investment Research Advisors Inc, a registered investment advisor, Cambridge and Thimbleberry Financial are not affiliated.