A credit card can be an emergency fund
It can be done, although it's not the best route for everyone.
It's a commonly accepted rule of personal finance that one should save three to six months’ worth of expenses in an emergency fund. Conventional wisdom dictates that you stash your cash in a high-interest savings account or maybe a short-term high-yield CD. The key is to have ready access to the cash in a true emergency.
Confession time: I've never kept three to six months’ worth of cash sitting in a bank account and don't plan to. In an emergency, I can tap investment accounts, a home-equity line of credit, or yes, even the dreaded credit card. The question for today is whether it's a smart money move to rely on credit cards as your financial backstop.
If you have an unpaid credit card balance and not much saved up in emergency savings I need you to listen up. My advice has changed.
I want you to only pay the minimum due on your credit card balance and instead make it your top priority to build as much of an emergency cash fund as you can.
Her rationale, which you can read for yourself, is that the credit card companies may reduce your credit, raise your interest rates, or even close your account. True enough. I know one person whose credit limit was reduced dollar-for-dollar as that person paid down the balance. And we've heard about this a lot in the news because reporters found folks who were unfortunate enough to find themselves in these circumstances. (Reporters didn't track down the folks who had no change to their credit cards, but if a reporter is out there looking for such a person, feel free to contact me.)
On the flip side of this issue we find Liz Pulliam Weston. In an article called “The $0 emergency fund,” Liz argues that for some a credit card or line of credit is a perfectly viable emergency fund. Why hold money in a savings account paying 1% or 2% while your credit card debt is costing you 10%, 15%, or even 20% interest?
- Video: How to save for an emergency
What are the advantages and disadvantages of using a credit card for an emergency fund? We've touched on both above, but let's list them out here:
- Availability of credit. As noted above, there is no guarantee that the credit you have available today will be there tomorrow. Lose a job and fall behind on some payments, and the credit card company could close your account. I suspect that each individual has a pretty good idea of how real this risk is, and knowing your credit score can help better evaluate this risk.
- Cost of credit. Credit card debt rolled over from month to month can become very expensive. There are ways to mitigate this risk, including using low-interest cards, but it's still a risk to consider.
- Lack of discipline. If you are unable to control your use of credit cards, relying on a card for emergencies may be a recipe for disaster. Either learn to control your spending habits or get rid of the credit cards.
- Puts cash to best use. The most significant advantage to relying on a credit card for emergencies is the ability to put your available cash to its highest and best use. Rather than putting cash in a savings account paying 1% interest, you can apply the cash to high-interest credit card debt, a car loan, or perhaps line of credit.
While I list only one advantage to using a card in emergencies, it's a significant advantage. In fact, it is similar to the approach recommended by Dave Ramsey. He hates credit cards, of course, but he recommends saving just $1,000 as an emergency fund and then applying all available cash to nonmortgage debt. In a true emergency that exceeds $1,000, you'd be left relying on credit. And this is roughly the approach I take. The only nonmortgage debt we have is a home-equity line of credit, and we use all available cash to pay it down.
Tips for using a credit card for emergencies
If you do decide to rely on a credit card as an emergency fund, here are some tips to consider.
- Make sure to pay down your debt. Make sure that the money you would have saved for emergencies is used to actually lower your debt. Sometimes the extra cash can make us spend more. Your total debt should be going down every month.
- Consider getting a separate card. If you already have credit cards with balances, it may be helpful to get a separate card just for emergencies. This is particularly important if your current card(s) is near its credit limit. With a separate card, you can file it away and use it only in true emergencies.
- Charge card vs. credit card. A charge card, unlike a credit card, must be paid in full each month. The advantage is that it imposes discipline on your spending habits and money-management skills. And because it must be paid off in full each month, there are no interest charges. The downside is that you may need to borrow the money for longer than a month. But for short-term emergencies, a charge card may be ideal.
- Use a no-fee credit card. One disadvantage of a charge card is that they typically have an annual fee. With a traditional credit card, you can get a no-fee card.
- Avoid a cash advance. With a cash advance, you typically pay a percentage of the amount borrowed and a high interest rate with no grace period. It's one thing to use a card to pay for an emergency car repair or hospital visit, but avoid a cash advance at all costs.
What's your take? Is relying on a credit card in case of an emergency a good or bad idea?
Related reading at The Dough Roller:
Copyright © 2013 Microsoft. All rights reserved.
Fundamental company data and historical chart data provided by Morningstar Inc. Real-time index quotes and delayed quotes supplied by Morningstar Inc. Quotes delayed by up to 15 minutes, except where indicated otherwise. Fund summary, fund performance and dividend data provided by Morningstar Inc. Analyst recommendations provided by Zacks Investment Research. StockScouter data provided by Verus Analytics. IPO data provided by Hoover's Inc. Index membership data provided by Morningstar Inc.
ABOUT SMART SPENDING
LATEST BLOG POSTS
Even those who don't like to shop are probably hitting the stores this month. Here's what to be on the lookout for and here's what to avoid.