Caution when considering a HELOC to supplement living expenses

Getting a full picture of the financial trade-off

Through no fault of their own, a family may find themselves in the position where their income is not keeping up with their cost of living. Whether operating under one or two incomes, one option they may be considering is a home equity line of credit (HELOC) to supplement their household needs.

A HELOC can indeed provide breathing room to a family, but preferably it is coupled with a plan on how they will emerge from that pause when their finances are back on track.

When an emergency fund isn’t enough

On a short-term basis, borrowed funds may be necessary to bridge the gap if there are expenses in excess of income. For example, someone may become unexpectedly unemployed and doesn’t have an emergency fund, or needs to stretch out that emergency fund to accommodate a longer transition back to work.

Still, it should be appreciated that like any borrowing, this is using future income to support current living costs, which can become unsustainable if one is not careful. Once beyond the employment gap and stabilized, the elimination of the line of credit ought to be a top priority.

Tax cost of non-deductible interest

Interest may be tax-deductible when money is borrowed for business or investment purposes. But if loan proceeds are being used to “live on”, those are non-deductible personal expenses. The person’s other income must be earned and taxed before cash is then available to pay the interest charges.

With each additional draw on the line of credit, interest will become an increasing drag on that other income. The build-up may be slow, but it will progressively reduce the spendable amount of those other income sources, again bringing into question the sustainability of the practice.

Accordingly, there must be a plan as to how and when the principal is to be paid down/off, else it becomes so large that only the sale of the home will be sufficient to pay off the debt. This could be especially damaging if market conditions are not in a seller’s favour when the homeowner may be compelled to take action.

Appeal and concession of capitalized interest

With some loans – which is fundamentally the nature of a line of credit – the lender may not require regular principal payments. Or, the lender may permit some or all of the interest to be capitalized to the principal.

While this may be appealing for immediate cash flow, it results in faster growing debt. The borrower remains responsible for the interest on the principal, and must now pay interest on the interest on a continuing basis.

That’s the compounding effect that is often highlighted when investments grow through reinvested income, but here it’s working in the opposite direction.

Compound interest as an expense will erode home equity at an accelerated pace if not understood, monitored and serviced. In addition, unlike investments that have an open-ended opportunity to grow in a positive direction, a lender will have a maximum limit for a line of credit, generally tied to the practical boundary of (a percentage of) the market value of the property that is the collateral.

Aging-in-place in retirement

Longer term, particularly in retirement, a homeowner/borrower must be extra cautious about the effect this may have on their future housing options. Downsizing to a smaller property may be part of one’s financial plan, but just how far ‘down’ depends on how much is realized on the sale of a current home.

Most people are on a fixed income in retirement. Hoped-for inheritances and lottery windfalls aside, there will likely be no new income sources or capital materializing in future. Once people begin to draw on a HELOC at this stage of life, it can be a one-way path. With no other way to allow them to eliminate the line of credit, it could end up as a hefty closing cost taken out of the proceeds on sale.

Ideally, this is a considered and conscious decision that allows an individual or couple to remain in comfortable, familiar surroundings for as long as possible. In fact, with informed planning, it can be a carefully controlled process of aligning money to milestones, be that downsized ownership, seniors’ rental, assisted living or long-term care.

So, whether it’s short-term or long-term, it’s best if there is a plan when contemplating a HELOC. Be clear at the outset what it is intended to bridge from and to, in terms of time, money and lifestyle requirements. Then, keep track of the accumulation, and be prepared for those next steps once your “to” is on the horizon.

Building your emergency fund

Getting yours going, and knowing when & how to use it

In the classic sci-fi novel Ender’s Game, gifted children play simulated battle games with aliens at the edge of the universe, until <<spoiler alert>> the title character realizes during an especially intense sequence that he’s in the midst of the real thing, and everything to that point has just been practice.

When you last contemplated your emergency fund, a global pandemic would have been well at the perimeter of possibilities. And yet, that’s what we all just experienced. How comfortable were you with how your finances fared in-the-moment, and how confident are you that you’re ready for a future crunch?

Positioning an emergency fund in relation to regular budgeting

If you had an emergency fund in place, you may still have found yourself asking: Is this the trigger, how much do I take, when and for what? And if you didn’t have one but were fortunate enough not to have been too displaced from your regular earning routine, you were probably jolted into thinking about finally getting one going.

Regular budgeting addresses recurring expenses, plus reserves for periodic capital outlays. Insurance is for the extreme where there are very rare but very costly events. An emergency fund lies between.

This fund allows you to sustain your household in a time of crisis – whether that’s an unexpected injury to you or a family member, job loss or a global pandemic – while expenses continue to pile up.

How and when to use an emergency fund depends on how you define “emergency.” Commit yourself to the above definition when you begin saving so that these carefully targeted savings are preserved for truly pressing needs, and not depleted on emotional wants.

Guidance for using your emergency fund

Like Ender’s alien battle, the pandemic pushed many of us out of practice mode and into active monitoring and logging of our spending. Whether or not that describes you, we can all learn from this painful episode, to help inform how we’ll use our emergency funds in future:

- The immediate non-negotiable needs are food and safety. You can cut down on these expenses by shopping brand-consciously, reducing cost-per-unit by buying in (sensible) volume, and being extra vigilant about portioning and waste.
- Shelter costs like rent/mortgage and utilities are next, as interest and penalties on short/skipped payments will quickly compound the emotional and money stress, further impairing your finances in the recovery time to follow. In the case of a widespread disaster (as it was with the pandemic), government support may be available, but if it is more localized or specific to your family alone, your financial resources will bear the primary or sole burden.
- Dispensing with all discretionaries may not be practical as you hunker down for the days and weeks of any extended emergency period, but try to be selective about the prudent pleasures you choose.
- Suspend luxuries and harbour no regrets. Keep your focus on the present, comforted that yesterday’s conscientious saving actions and today’s prudent spending choices will improve your prospects tomorrow.
- Log where your money is coming from and where it’s going, so you can manage within your changing means. That’s a good habit in good times, and critical in a crisis. As was the case in the pandemic, you may have a bit more time on your hands (unwanted though it may be) to focus on budgeting, which could be a catalyst to reinforce your good money habits over the long term.

Building a fund for future crises

An emergency fund’s purpose is to have money accessible for a specific number of months to carry you through the emergency. But how many? Start by planning for the most likely emergency: an employment gap.

1. Based on your industry, geography and individual skills, how long do you think it would take to get re-situated? As you don’t know what the economic conditions will be, choose a figure between the best-case and worst-case scenarios to obtain a reasonable goal for the number of months your emergency fund may be needed.
2. You may anticipate a payment from your employer on a termination. The amount will depend on the terms of your contract, including your income, seniority and the circumstances of your parting. While this should not be ignored, be cautious and conservative in your assumptions. If the situation is contentious, there may be a delay in reaching a resolution, as well as legal/professional fees you may have to spend before receiving the amount.
3. While losing income is painful, what matters most in an emergency is spending.
  - Tally up your outlays as shown on your banking and credit card statements over the last year, taking out anything truly extraordinary and deducting recurring items you may be able to defer for a few months.
  - Divide the total above by 12 for a monthly average, and multiply by the chosen number of months you decided upon in step 1 – This is your lower dollar limit.
  - Add back the deferred items to estimate how long until those deferrals will be exhausted, again dividing by 12 and multiplying by your target months from step 1 – This is your upper dollar limit.
  - Choose a number between the lower and upper limits for your target emergency fund. Decide whether and how much this may be reduced by an anticipated terminal payment from step 2, again being prudently cautious in your approach.
4. Next, decide how much you will make as a weekly deposit to the fund, ideally aligned with your pay cycle. Assign either a percentage or dollar amount you can commit to, even if it’s a small figure.
5. Now, the gut check:
  - Divide your chosen target from step 3 by your weekly deposit commitment in step 4. This will show how many weeks it will take for you to accumulate your target emergency fund.
  - If you feel a knot forming in your abdomen, go back and see where you may be able to make some adjustments. Balance that unease against the discomfort from the current budgetary sacrifice in order to arrive at a manageable medium.

Supporting role for a line of credit

As a kicker, an oft-suggested alternative to an emergency fund is a line of credit at the ready with your bank or credit union. But for some people, taking on debt at a time of financial stress may be an uncomfortable proposition.

Even so, establishing a line of credit can be an effective complement to an emergency fund, knowing that it will be there to fill the gap if an emergency hits before the fund reaches its accumulation target.

Registered or non-registered?

Your RRSP is not an appropriate choice as an emergency fund. With withholding tax as much as 30%, you will have to take a higher gross amount to net to what you need. And if the withholding is less than the actual tax due, you’ll be scrambling to come up with cash at tax filing time next year. Withdrawing from an RRSP for an emergency also puts retirement at risk. Keep these two needs separated.

On the other hand, the TFSA is well suited for emergency needs. With no tax to deplete withdrawals, budgeting is much more transparent. Withdrawals are also entitled to the usual TFSA re-contribution credit, which can be both the motivation and target for replenishment once the emergency passes.

My 3-reserve approach: Emergency–Bridge–Buffer

[This article also posted to Linkedin here]

Last week I posted a comment on social media linking back to an FP Canada survey that noted, among other interesting observations, that “almost four in 10 (37%) Canadians say they rarely or never put money aside in an emergency account.”

In my cover comment, I mentioned that I myself had three types of such funds or reserves – emergency, bridge and buffers – and that they served me well recently when I was going through career transition. (For those not familiar with the latest lingo, that means I was between employers.)

Someone asked me what I meant, and how I quantify those. I gave a short response (it being fleeting social media), but thought I’d provide here a bit more detailed explanation of how I view and use these three types of reserves.

What’s your emergency?

The problem with a blanket emergency fund is that most people don’t define what constitutes an emergency.

The classic ‘I’ll know it when I see it’ view is no help. That could make it anything from just a slush fund – as in literally, ‘I could really go me a slush on this hot day’ – all the way up to it never being touched because it would require worldwide armageddon.

In my 3-part distinction, an emergency is something that is truly unexpected due to its nature and/or timing, that demands an immediate and significant financial response. It’s a medical diagnosis no-one expects, or property damage beyond what you reasonably insured for, or maybe even a new addition to the family well after you’ve auctioned all the stuffies on Kijiji.

So, mea culpa, I’m not giving it a specific definition myself. I am however setting aside an amount every week (which was reduced but not paused during career transition) so that we’re prepared for that non-ventuality. If that emergency doesn’t come as we’re nearing our work-optional threshold, it may accelerate that date a bit, keeping in mind (and keeping in reserve) that emergencies can happen at any life stage.

A bridge to … when

I started with the emergency fund above, in keeping with what people expect to discuss as the primary reserve. I too have written using this umbrella reference. Getting more nit-picky on how I parse it out personally, what many people call an emergency fund, I call a bridge fund. So despite that I’m writing on it second, I believe this to be the first priority topic and target among the three.

It’s a bridge fund because it allows you to keep moving forward in your life journey when the road beneath you has been washed away.

With all due respect to thumbnail wisdom, an arbitrary target like 3 or 6 months has nothing to do with specific circumstances, though I wouldn’t argue against this as impetus to begin funding one’s reserve.

Ideally your bridge fund is based on how much time it takes to get re-situated or re-employed, based on a clear understanding of yourself, your skills and the state of your industry. That’s on the income side, or more aptly the absence of income.

Express that in terms of weeks and multiply it by your ‘lean budget’ (deferring discretionaries and luxuries), and there you have your accumulation target. Now determine how much you can devote to that from your current weekly budget and that tells you how long it will take to get your bridge fully funded.

Buffering up the budget

The last component – buffering – is a practical application of the budget categories we use to keep our financial lives in order. I’ll assume here that you are not just using a single current/chequing account for all purposes.

For me, there are about 10 major categories, with 50 or so individual line items. Of these, a couple dozen warrant their own distinct sub-account at your favourite financial institution. Though I’m paid bi-weekly, there is an auto-transfer from my main account to each of these sub-accounts, regardless whether I expect to spend anything that particular week. For example, my electric bill is paid monthly, but the account gets a weekly drip.

Now here is where the buffering comes in. My spreadsheet sums actual past monthly amounts in each category to arrive at an average monthly cost. (I update about quarterly.) This then is divided by 4 for the weekly drip. The benign deception (to myself) is that though I’ve effectively divided by 48, the drip occurs in every one of the actual 52 weeks. Thus each account is modestly indexed by about 2% over the year.

It’s a small and almost unnoticeable cost for me to pay (myself) over the year. In truth, I started doing this as a way to slowly index for year-to-year inflation, rather than having an unpleasant surprise that shocks the budget and knocks my resolve every January.

And yes, I do skim out some from the accounts occasionally, but I haven’t been compelled to top-up any of them in any serious way. In fact for the larger ones, like the appliance account, it’s a couple months ahead of need, despite having to use it for its intended purpose twice this last year.

That’s it, three ways that I use reserves to create comfort space in my finances.