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Why Your Credit Needs an Emergency Fund
Believe it or not, neither the amount of money you earn nor how much you have in the bank or in your wallet has an impact on your credit scores.
Credit scoring models, like FICO and VantageScore, don’t consider your income or other wealth related metrics. This means you have the potential to earn great credit scores whether you earn millions of dollars per year or you earn the minimum wage.
But although income and wealth metrics aren’t factored into your credit scores, a lack of savings can still hurt your credit, albeit indirectly. For example, if you don’t have an emergency fund, you’re putting your financial and credit health at risk.
Emergencies are, by definition, urgent. If you don’t have money set aside to cover unexpected, immediate expenses, you’ll most likely have to borrow the money to cover them. Depending on the urgency of your situation, you may even feel forced to use a financing option that could hurt your credit or cost you a lot of money in the long run.
Here are a couple of common ways people cover urgent expenses when they don’t have an emergency fund.
Option #1: Using a Credit Card
Using a credit card to cover an emergency expense is easy, if you have enough available credit on your account. However, easy isn’t synonymous with good.
When you use a credit card to cover a large expense, like a car repair bill, it can turn into a costly mistake. Interest rates on credit card accounts are notoriously high, often in the high teens or higher. If you charge more on your credit card than you can afford to pay off in a month, those high interest fees will pile up quickly.
For example, say you make a $5,000 charge on your credit card with a 20% APR but you can only afford to pay $100 per month on the debt. If you keep paying only $100 per month, it would take you nine years and one month to pay off that expense. During that time, you would pay an extra $5,840 in interest fees – more than double the initial cost, and an expense that could have been avoided entirely if you had an emergency fund.
To make matters worse, that $5,000 in new credit card debt may damage your credit scores even if you make every payment on time. Why? Because credit scoring models pay attention to the relationship between your credit card limits and your credit card balances. When your credit reports show that you’re utilizing a high percentage of your available credit limits, your scores will likely suffer.
- Read more: Why Is Credit Utilization Such a Big Deal?
Option #2: Taking Out a Loan
If you have decent credit, taking out a personal loan from your bank to cover an emergency expense might not be such a bad idea. With good credit, you may be able to obtain a reasonable interest rate and affordable monthly payments.
However, when you have credit problems, getting a quick loan at a low interest rate might not be possible. In desperation, many people feel forced to turn to high-rate loans from online lenders. Even worse, some people will turn to payday lenders, title loan companies, and other short-term, asset-based lending options. The annualized interest rates on these types of loans can reach as high as several hundred percent, and some of them are even outlawed in certain states.
It’s easy to get in over your head financially when you take out high interest loans. Before you know it, you might have trouble keeping up with your payments, and a downward credit score spiral could begin.
Start Your Emergency Fund
Think about the recent partial government shutdown that delayed one or two paychecks for some government workers. There was a real possibility that, if the shutdown went on for several more months, people could have defaulted on car loans, credit card bills, and even mortgages. The need for an emergency fund is legitimate and real.
Now think about what would happen if you lost your job or your hours were cut back. How long could you make your payments?
Building an emergency fund doesn’t just protect you financially; it’s also a smart way to protect your credit. All it takes is setting aside some money each week or each month — even just $5 or $10 a week is a start — into a high-interest savings account. Make the transfer automatic, so you don’t forget and you don’t miss it. (Here’s a step-by-step guide to help you get started building a healthy emergency fund of your own.)
Even if you don’t feel like you can afford to save money aggressively right now, make the decision to get started with small amounts. When it comes to saving money, something is always better than nothing – no matter how small.
More by John Ulzheimer:
- Three Ways to Raise Your Credit Score Fast
- The Perfect Credit Score (and Why You Shouldn’t Obsess Over It)
- UltraFICO vs. Experian Boost: Two New Ways to Build Your Credit
John Ulzheimer is an expert on credit reporting, credit scoring, and identity theft. The author of four books on the subject, Ulzheimer has been featured thousands of times over the past decade in media outlets including the Wall Street Journal, NBC Nightly News, The Los Angeles Times, CNBC, and countless others. With professional experience at both Equifax and FICO, Ulzheimer is the only credit expert who actually comes from the credit industry. He has been an expert witness in over 230 credit related lawsuits and has been qualified to testify in both federal and state courts on the topic of consumer credit.