If you happen to follow me on Twitter, you may have noticed I was recently looking into different HELOC options. The first lesson I learned was to never give a real phone number to LendingTree when attempting to check rates. Luckily, I thought ahead and used a google voice number instead of my regular cell phone! Several lenders have been bombarding the number since which would be terrible if they went to the phone I carry around in my pocket most of the day. While I haven’t actually answered a call (probably why they keep calling…), the voicemails all seem to be based around refinancing instead of the HELOC I was looking for!
While a few people on Twitter seemed to think I was in the market for an actual loan, my true goal was to explore the different ways a HELOC could be used (or not used), how much it costs, and whether or not a financially savvy person could profit off of it in a safe, reliable way. This article will explore what I learned and if the title didn’t give it away yet, why we plan to start using a HELOC in conjunction with our mortgage to get a much higher return on our emergency fund.
If you happen to have a decent amount of equity in your house, some cash savings, and a bit of financial discipline, you might be able to do the same!
Having Both Debt and Cash is Inefficient
What started me down this path was a small itch that appeared whenever I take a look at the different interest rates in our lives. We’re currently paying one bank 4% interest on the money we borrowed from them to buy a house (in the form of a mortgage payment). On the other hand, a different bank is only paying us 1% to borrow money from us (in the form of a high interest savings account)!
That’s a difference of 3% which can add up significantly over time thanks to the power of compounding.
Unfortunately, there’s no simple way to close this gap. It’s certainly possible to take our cash savings and apply it to the principal (and start gaining 4% on it instead of 1%), but then we can’t access it in an efficient way if we eventually need to use it! Tying up an emergency fund in home equity is dangerous if you don’t have a way to get it back out quickly.
Once upon a time, mortgage lenders offered a “mortgage savings account” which would have been perfect. Any money that was currently in the savings account would offset the principal of the mortgage when interest was calculated. For example, if you owed $100k on your mortgage, but kept $20k in the mortgage savings account, then you would only be paying interest on $80k each month. This allows you to gain an effective interest rate on your cash savings equal to your mortgage rate, but without losing any of the flexibility of cash. Money could be withdrawn from the account at any time for any reason, much like a standard savings account.
Of course, most of these mortgage savings accounts were tied to sketchy mortgage lending practices right before the housing crash and completely disappeared in the US not long after. I’ve heard that they still exist (and are even common) in some other countries, but I haven’t been able to find a US bank that offers them as of writing this post.
For some people, it may be possible to re-create this sort of ideal mortgage based savings account through the use of a HELOC and that’s what we’ll explore below.
How HELOC’s Work
I don’t want to get into all the nitty-gritty details on HELOCs here, so I’ll try to summarize in bullet points and link to a better resource if you’d like more information.
- HELOC stands for Home Equity Line of Credit and that’s exactly what it is
- You can think of a HELOC like a credit card, except the line of credit is backed by existing equity in your home
- A HELOC will typically only be granted up to the 80% of the value of your home (LTV), after taking any existing mortgages into account
- Cash can be pulled out of the HELOC to do just about anything, it’s cash
- When a balance exists on the HELOC, you will have to make monthly payments including interest at whatever rate the HELOC is currently at
- The rates on HELOCs are variable, often based off of the current prime rate
- Different banks may have various fees and minimum requirements for opening and maintaining a HELOC aside from the interest itself
- The interest paid towards a HELOC may be tax-deductible much like mortgage interest
More information on HELOCs: Click Here for a Nolo article on HELOC Basics
Are You Eligible for a HELOC?
First, in order to even thing about using the HELOC strategy I describe below, you need to own a home.
Next, you will need some equity built up in that home. Most lenders will only issue a HELOC up to 80% LTV on your house, which means your outstanding mortgage balance (if any) must be below that. Ideally, the amount of equity beyond 80% LTV you have should at least be equal to the amount of cash savings you plan to execute this with, ideally more.
Finally, you will need a good credit score and a reasonable debt to income ratio in order to qualify and get a reasonable rate.
Beyond the eligibility requirements a bank will look at above, I would also encourage you to only pursue this if you are financially disciplined, organized, and can handle credit responsibly.
Whether or not it makes sense for you to open a HELOC will depend on the math we’ll explore below. It appears to work for us, but might not work for everyone.
Why You Might Want A HELOC
Back to the inefficiency we discussed above, it would be ideal if our cash savings could earn at the same rate as our mortgage (4%) instead of 3% lower in our 1% savings account. Putting our cash savings directly towards the mortgage principal would solve this problem, but creates the new problem of very poor liquidity. Not being able to access money in an efficient manner would be terrible in a true emergency.
If you have access to a HELOC, it can serve the function of opening up quick access to equity in your home whenever you need it.
In theory this would solve the problem perfectly, but a HELOC doesn’t come without costs. We’ll first have to run the numbers for a few different scenarios to see if the opportunity cost of keeping our cash savings in a 1% account offsets the potential costs that come with relying on a HELOC to access emergency funds.
The Logistics of Replacing Your Emergency Fund with a HELOC
- Open a HELOC, ideally with little to no fees and the lowest rate you can get
- I’ve found several banks that will open one for $0 in fees and no minimum withdrawal requirement, so it might not cost you a dime to get started.
- Take your emergency fund and make an extra principal payment towards your mortgage for the entire amount
- That money is now effectively earning the interest rate of your mortgage instead of whatever account it was sitting in before.
- If you need funds that would normally come from your emergency fund, withdraw them from the HELOC instead
- Your HELOC may come with checks or a debit card to withdraw, or you can simply make a transfer from it to your regular bank account online.
- Use excess cash flow after the emergency to pay the HELOC back down to $0
- Rinse and repeat from Step 3 as necessary
Scenario 1: The Ideal Emergency-Free Case
In a perfect world, you’ll never need to access the funds you’ve set aside for an emergency and they will just slowly grow in the background of your life. While this sounds nice, it’s not particularly practical as many people will probably run into some situation where these funds are required. Running the numbers for this scenario can be useful though, because it sets a ceiling on what kind of benefit you can gain by using our emergency fund to pay down our mortgage, and then using a HELOC as our new emergency fund.
In order to get the annual benefit, we simply have to subtract your mortgage interest rate from your savings account interest rate, then multiply by the amount of your emergency fund.
As this “ideal” scenario never requires us to actually pull money out of the HELOC, the rate doesn’t even matter. In fact, it’s entirely possible to open a HELOC and never use it. Depending on the bank, it might not even cost you any money to just have it available.
For our own example:
- Mortgage Interest Rate: 4.0%
- Savings Account Interest Rate: 1.0%
- Cash Emergency Fund: $18,000
Our Maximum Annual Benefit of Using a HELOC instead of a Savings Account:
- (4.0% – 1.0%) * $18,000 = $540
An extra $540 per year, which could then be invested to compound over time, is no insignificant sum!
Of course, this is the ideal case with our own personal numbers, so let’s look at some other possibilities.
Scenario 2: The Perpetual Emergency Case
In the opposite of a perfect world, you would always need emergency funding and would never be able to save anything! If this unfortunate situation starts up right after you decide to move your emergency fund into your mortgage principal, then you will be stuck pulling that money out of the HELOC instead and will be paying the rate of the HELOC instead of just losing out on your 1% savings rate. The good news is that the money you put towards your mortgage will still keep paying dividends in the meantime.
If the emergency keeps up indefinitely, then you’ll be stuck paying your HELOC’s rate on the entire size of the old emergency fund until the end of time and will never be able to retire.
For this unfortunate (but hopefully very low probability) situation, we can multiply the difference in the rate of the HELOC and the mortgage by the size of your emergency fund to find our worst case scenario. Of course, HELOC rates are variable, so it is possible for it to get worse as time goes on if you can truly never repay it.
- Size of Emergency Fund: $18,000
- HELOC Interest Rate: 5.0%
- Mortgage Interest Rate: 4.0%
- Worst case scenario annual cost: $180 ($18,000 x (5.0% – 4.0%))
That doesn’t seem so bad compared to the $540 in potential profit! As you’ll see below, this entire life hack depends on your ability to replenish your emergency fund (or pay down the HELOC) quickly, which I think is very possible for most people saving for FI. It’s people with a high savings rate and a low probability of large emergencies popping up that stand to benefit the most from this strategy.
Scenario 3: A Conservative Case Somewhere In Between
In reality, most people in the pursuit of financial independence have a high savings rate which has a double effect on emergency funds.
First, the chances of needing extra cash in an emergency is diminished because of higher than average monthly cash flow. Any money that would normally be saved and invested can be redirected towards unexpected expenses as they arise, without ever having to tap into the actual emergency fund.
Second, in the situation where you do need to tap into the emergency fund, it is often possible to replenish the funds quickly by re-directing excess cash flow towards it instead of investments.
Despite these two benefits, let’s calculate a conservatively poor scenario that manages to drain the entire emergency fund yearly, which then takes 5 months to replenish. This would be equivalent to someone that holds a 5 month emergency fund and has a 50% savings rate.
At a 50% savings rate, you can replenish one month of your emergency fund for every month worked.
This means that half of the year, the HELOC is carrying a balance while the other half of the year it sits unused. The first month the HELOC carries the full balance, then it decreases over the next 5 months until it’s entirely paid back down to $0 at the end of the 6th month. The average balance of the HELOC over these 6 months is exactly half of the total emergency fund. The average balance across the entire year would then be half of that, or a quarter of the emergency fund, as the HELOC sits unused at a $0 balance the other half of the year.
We can then use this number (25% of the emergency fund total) to calculate whether or not we are still seeing a benefit from using the HELOC instead of a savings account by subtracting it from the ideal number we calculated above.
- Mortgage Interest Rate: 4.0%
- Savings Account Rate: 1.0%
- HELOC Rate: 5.0%
- Size of Emergency Fund: $18,000
Conservative Annual Benefit Estimate of Using a HELOC instead of a Savings Account:
- Average HELOC Balance: $4,500 (25% of $18,000)
- Interest Paid on HELOC: $225 (5.0% x $4,500)
- Interest Not Paid on Mortgage because that’s where our $18k in cash is: $720 (4.0% x $18,000)
- Average Balance that would have been in our old Savings Account E-fund: $13,500 ($18,000 – $4,500)
- Interest Not Gained because we no longer use a Savings Account: $135 (1.0% x $13,500)
- Total Annual Profit of HELOC Strategy for this Scenario: $360 ($720 – $225 – $135)
As you can see, even in what I would consider an unfortunate annual use of an emergency fund, the HELOC strategy described above still comes out ahead of just keeping your emergency fund in a savings account!
Here’s the same example in excel form that includes the real cash flow numbers I was looking at when considering this strategy for ourselves. I focused on the total interest that we would be paying and gaining both with the HELOC strategy and without. I subtract any interest that would be paid on the mortgage balance (at 4%) and HELOC (at 5%) each month, but then add back in interest that would be gained from having cash in a savings account (at 1%). I ran the numbers over 2 years which means there was 2 instances of the “emergency fund drain” described in this scenario. We can then compare the total interest paid in each example to see which one came out ahead and by how much:
The numbers in yellow at the very bottom of each picture account for the total interest paid in each plan. By subtracting the two values from each other, we find that the HELOC strategy ended with us paying $774.21 less in interest over the two years. That number is a little higher than our calculation of $720 above ($360 x 2 years) because the 4% saved on the mortgage balance essentially compounds over time to create even more savings. And that’s with having to fully drain our emergency fund twice and make interest payments towards the HELOC!
Why This HELOC Strategy Works for Us
Each of the scenarios above uses a close approximation of our own numbers to calculate the potential savings and costs in different possible scenarios. The HELOC strategy works so well for us because of the reason I listed above, we are saving a high percentage of our income each month. This excess cash flow allows us to use our emergency fund less and replenish it quickly in the event we ever do need to use it.
One way to look at it is this: For every month the HELOC sits at a $0 balance (no emergencies), we are profiting $45 by having our cash savings in our mortgage principal instead of a savings account. Over time, we should have many more months without an emergency than months with one.
Even when we do have an emergency and need to drain the account, there is hardly any cost to do so! The only cost will be on the difference between our mortgage rate and the HELOC rate (1% in our example numbers above) multiplied by the average balance of the HELOC. This is because even though you are paying the HELOC rate on the balance, you are still profiting your mortgage rate each and every month because you made that extra principal payment at the beginning!
Another way to look at it is the break-even point. What is the average utilization of the emergency fund in which both strategies are equivalent? The approximate answer is simply the ratio of your mortgage rate to the HELOC rate! I say approximate because the compounding of the mortgage and the interest on the savings account balance both offset it slightly.
For the numbers we were using above, this would be 80% (4.0% / 5.0%) or an approximate average HELOC balance of $14,400 (80% of $18,000).
A little trial and error with the excel sheet I was using revealed that the real average HELOC balance that will create the break-even point is $14,238.75 for the example numbers we’ve been using throughout this page.
That means if we expect our average monthly use of your emergency fund to remain under 80%, then we will profit by using a HELOC and sending our cash emergency fund to pay down our mortgage principal. As we haven’t even had to touch our emergency fund since we set it up years ago (knock on wood!), the average use over time shouldn’t even be close to 80%. If we would have started this strategy 3 years ago, it would take a crazy emergency that would drain our entire fund for 12 years just to bring us back to even!
Every year we don’t start doing this we’re leaving hundreds of dollars on the table for taking on a very low amount of risk (more than 4 out of every 5 years being a catastrophic emergency kind of risk). I can’t believe I didn’t run the numbers on this sooner, but at least we’ve discovered it now!
Why This HELOC Strategy Might Not Work For You
A lot of the math above has been based on our own personal numbers and I will be the first to acknowledge that this strategy isn’t a good idea for most.
- It requires financial discipline to not spend money out of the HELOC unnecessarily.
- It requires a level of comfort with having little to no cash buffer sitting around in your accounts.
- It requires approximate estimation of your worst-case scenario emergency fund usage over time.
- It requires slightly higher cash-flow during a worst-case scenario because of the minimum payments on the HELOC. This is because your mortgage payment remains constant despite the extra payment we made early on.
- It benefits greatly from a high savings rate that has the ability to replenish emergency funds quickly.
Fortunately, I think the financial independence community is the perfect candidate for meeting and exceeding the requirements above! Of course not everyone in the FI community will be comfortable bringing their cash emergency fund down to $0, but even just reducing your emergency fund and moving the rest into your mortgage principal could allow you to profit from this strategy.
In addition to the above requirements, I recommend calculating your own potential profit and downside.
How To Get Started Yourself
If the above strategy and potential profits from it caught your attention and you meet the requirements above, then the first step is to shop around for a HELOC with a good rate. I used 5% in my example, but this is actually on the high end of different rates that I was able to find at the time of writing. I kept it anyway to show that the HELOC doesn’t necessarily have to be equal or cheaper than your current mortgage rate (but of course that would help!).
In fact, the best rate I found advertised online was from Third Federal Savings and Loan which is currently at prime minus 0.51% or 3.49% for HELOCs over $50,000. That’s even cheaper than our mortgage rate! But don’t forget HELOC rates are variable, so this will potentially go up over time. Third Federal even advertises a “lowest rate guarantee” that will pay out $1,000 if you can find someone with a lower HELOC rate!
If you’re able to find a HELOC with little or no fees that has a lower rate than your mortgage, you can effectively play interest arbitrage by pulling money out of the HELOC and putting it towards the mortgage. This increases your cash flow requirement each month as you’ll have the additional HELOC payment, but you will accelerate your mortgage to some degree. This of course comes with it’s own bag of risks that are beyond the scope of this article. In general, I would advise against it!
Also, I don’t have any relation with Third Federal, they just happen to be the lowest rate I found searching around online. One downside to their offering is a $65 annual fee after the first year. This may make a higher rate with a different bank a better deal over time. Of course, this will depend on how much you actually end up using the HELOC.
I’d recommend asking any banks you currently have an account open with, the big banks seem to have higher rates in general, but offer different “rate discounts” depending on how much money you hold with them. Next, local credit unions may be your best bet, Danny Salgado on Twitter mentioned a prime minus 0.25% rate in Vancouver Washington in response to my HELOC tweet:
After you find a HELOC that might work for you, run the same calculations I ran above with your own numbers. Maybe you’re getting higher than 1% on your cash savings right now. Maybe you have a different interest rate on your mortgage. In most cases, I expect you will still be able to profit each year, but you’ll have to decide for yourself if it’s worth the effort. Don’t forget to subtract out any fees you are paying to open or maintain the HELOC year over year (it’s possible this is $0).
- Best Case Scenario Annual Profit: (Mortgage Rate – Savings Rate) * Size of Emergency Fund
- Worst Case Scenario Annual Loss: (HELOC Rate – Mortgage Rate) * Size of Emergency Fund
- Average Case Scenario Annual Profit/Loss: (Mortgage Rate * Size of Emergency Fund) – (HELOC Rate * Average HELOC Balance) – (Savings Rate * Average Savings Balance)
Not sure how to figure these numbers out? Let me know in the comments and I’ll do my best to help you out!
Overall, I’m super excited to try out this strategy myself and start profiting hundreds of dollars per year! What about you? Does this seem like a sound financial optimization or am I missing something that makes it way too risky for your liking? Let me know in the comments below and I’d love to talk about it.