You’ve probably heard it’s good to “have a credit card in case of an emergency”. I often hear that. Maybe that’s true. If it means using a credit card and then paying the total credit-card balance before any interest accrues.
What I don’t hear often enough, however, is that it’s a better idea to have a good-sized emergency fund. An emergency fund that is the first line of defense against an emergency. An emergency fund that means the credit card is held in reserve as the final, ultimate, utmost, definite last resort. When faced with an emergency, the first thing that comes to mind should be the emergency fund — not the credit card.
But “a credit card in case of an emergency” is what I hear again and again. It makes you think: Which earns more for the bank? Your emergency fund (which might earn a bit of interest for you) or a credit card (which earns interest and fees for the bank)? Who has more money to spend on advertising and the like? The banks or the people telling you that you need an emergency fund? One way or another, “emergency” and “credit card” have come to be linked together in the popular lexicon.
What’s wrong with using a credit card to deal with an emergency? Hundreds of dollars in interest charges, that’s what’s wrong with using a credit card to deal with an emergency. If you charge $1,000 on a credit card with the typical credit-card interest rate (of 20-something percent) and don’t pay it off completely the next month, you might eventually pay several hundred dollars in interest over the next several years. Using a credit card can double the cost of your emergency. As if the emergency didn’t cost enough by itself! The wrong way of “using a credit card in case of an emergency” is using a credit card to pay for whatever is needed to deal with an emergency even though you can’t pay the balance in full before any interest is added to the balance. It’s fine to use a credit card and then pay the credit card bill in its entirety with money taken out of your checking account and emergency fund.
Your emergency fund is the alternative to “you need a credit card to take care of emergencies”. Your E.F. should consist of at least, at a bare minimum, $1,000 in ready cash. You could keep it in your home, if you are sure it will be safe, which includes safe from the temptation that you will spend it for a non-emergency. Probably better to keep it in a savings account at a credit union or bank that will allow you to withdraw any amount at any time without penalty. Once you have your one-thousand-dollar emergency fund, you should consider increasing the amount to $2,000 or an amount equal to a 1% to 5% of your annual income (or $2000 if that’s higher than 5% of what you earn in a year). When you have achieved that goal, think in terms of something between 10% and 50% of your annual income.
When an actual emergency comes along (and it’s a matter of “when” not “if”), instead of borrowing money from a bank, by using a credit card, you “borrow” it from you emergency fund. Then, once you have taken care of the emergency, you “pay back” what you’ve taken out of your emergency fund by making regular deposits into the emergency fund account until the fund is built back up to where you it should be and is ready for the next emergency.
Just to be clear: If it’s my wife or kid in a broken-down car on the side of the road, I want them to have a credit card (and not a lot of cash). But I also want to have enough money in the bank to pay for the tow and the repair.
