Liquidity Matters: Will You Have Money to Face an Emergency?

A wise precautionary move for homeowners, according to common financial planning advice, is to establish a home-equity line of credit (HELOC).

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. (An 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.)

Since the recession began, however, many homeowners have 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. Not only are credit cards a highly expensive way to borrow, but — as with an HELOC — access to plastic credit may not be there when an emergency strikes.

Writing in the March 10, 2009 Wall Street Journal, banking analyst Meredith Whitney noted that card issuers are reducing credit limits at a rapid rate. She estimated that overall credit available to credit-card users will be cut by as much as 40% this year — and not just for folks who aren't paying their bills on time.

SAVING FOR A RAINY DAY

Liquidity matters — especially during a time of financial emergency. Without a source of available funds, you can get into trouble fast. And the current pullback in available credit — though it is certainly not affecting all homeowners or consumers equally — makes the point clearly: there is no reliable substitute for personal savings. This is why SMI stresses the need to set money aside "for a rainy day."

We recommend working toward an emergency-fund minimum of about $10,000, depending on your income. 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 current credit crunch 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 your mortgage as part of our Level 1 "Getting Debt-Free" goal. (Instead, we typically say it's okay to move on to Level 2 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 you earn only 2% on your savings and pay 6% on your house debt.

Paying down your mortgage is a great idea. We're all for it — at the right time. But we believe it should be secondary to establishing a healthy level of emergency savings.

The realities of today's economy are a good reminder of the wisdom in that approach.

Mark Biller is Sound Mind Investing's Executive Editor. His writings on a broad range of financial topics have been featured in a variety of national print and electronic media, and he has appeared as a financial commentator for various national and local radio programs. Mark is also the Senior Portfolio Manager of the SMI Funds.

Joseph Slife is a contributing author and editor for SMI. He spent 15 years with Crown Financial Ministries, co-writing articles with Larry Burkett and serving as executive producer for broadcasting. In addition to his work with SMI, Joseph is an adjunct instructor in the Dept. of Communication at Emmanuel College in Georgia.

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• Credit Cards Are the Next Credit Crunch | WallStreetJournal.com

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