Some people consider their home-equity line of credit (HELOC) or credit cards to be their emergency fund. But when it comes to being prepared for the financial equivalent of a rainy day, there's nothing like personal savings.
It isn't that maintaining a HELOC is a bad idea. In the event of a job loss or other financial emergency, the credit line becomes a source of ready cash, allowing you to easily tap the equity in your home. (A HELOC is different than a "home-equity loan." With a loan, you borrow money up front and pay interest. A credit line simply offers the option of borrowing should the need arise.)
Following the subprime mortgage crisis of 2008, however, many homeowners found out that counting on a home-equity line for emergencies isn't the same as having a cushion of cash savings to fall back on. When the economy started to soften, some banks began freezing even unused HELOCs in response to rising delinquency rates and general housing-price declines. Even some homeowners with good payment records and strong equity levels in their homes discovered their credit lines were being frozen, reduced, or closed. The fine print gives banks that option.
Lesson: You can't necessarily count on a home-equity line to be there when you need it most.
Don't count on your credit cards to tide you over, either. Credit cards are a highly expensive way to borrow, and — as with a HELOC — access to plastic credit may not be there when an emergency strikes. The recession prompted many card issuers to reduce credit limits, and not just for folks who weren't paying their bills on time.
Saving for a rainy day
Liquidity matters — especially during a time of financial crisis. Without a source of available funds, you can get into trouble fast. There simply is no reliable substitute for personal savings. This is why SMI stresses the need to set money aside for the financial storms everyone experiences from time to time.
We recommend working toward an emergency fund large enough to cover three to six months' worth of essential living expenses. (See our article The Wisdom and Foolishness of Saving Money.) Building such a fund requires sacrifice (i.e., living below your means), but that sacrifice is a key component in securing your long-term financial health.
The credit crunch brought on by the recession also illustrates why we typically don't recommend allocating every available dollar toward paying down mortgage debt. New readers who are strongly committed to debt reduction sometimes question why we don't include paying off a mortgage as part of our encouragement to become debt-free before moving on to building savings. (Instead, we typically say it's okay to move on to savings goals after paying off all consumer debts). Our view is that until a healthy emergency fund has been established, it's a higher priority to save for emergencies than to prepay a mortgage — even if the interest you can earn on savings is less than the rate you're paying for your mortgage.
Paying down your mortgage is a great idea. We're all for it — at the right time. But we believe a healthy emergency fund is a higher priority.