I treated my credit card as my emergency fund.
In late 2004, the brakes failed (in a nearly catastrophic fashion) on my 1997 Ford F150. For whatever reason, the brake cylinders chose to collapse as I was attempting to stop at a stoplight. I nearly caused a very large accident, but I managed to get stopped after swerving into another lane and running a red light.
The repair bill was pretty significant – about $300 more than I currently had in my checking account. I remember standing there flipping through the four or five credit cards I had at the time, trying to figure out which one had enough available credit to cover that bill.
Avoiding Using Credit Cards Irresponsbly
Personal finance 101 would have kept me out of this situation, but I didn’t have enough sense to have planned a bit for this brake problem. Instead, I believed that having some credit available on a credit card was just as good as an emergency fund.
That’s just horrible, horrible planning.
Why Using a Credit Card as an Emergency Fund is Poor Planning
Let’s say, on average, I have a major emergency that costs $1,000 once a year in my life. A car breaks down. A job is lost. A family member is ill and you need a plane ticket. There are countless emergencies that can happen in life, so I’m just using that $1,000 once a year emergency as an example.
If you sock away $20 a week into a savings account earning 1% interest, you’ll have that $1,000 once a year when you need it. The brakes aren’t a concern, nor is that emergency flight you have to take. Plus, you’ll earn a small amount of interest on that money – $5 to $10.
If you just spend that $20 a week on something unnecessary – and that’s what you will spend it on, because almost everyone has $20 worth of fat in their weekly budget – when the emergency comes, you’re putting that $1,000 on a credit card. At that point, you’re now making $80 a month payments on that credit card instead of socking it away. Even worse, you’re paying 20% interest or so on that credit card, meaning that over the course of the year, you’ll have to make two or three extra $80 payments just to cover the interest. And while you’re making those $80 payments, you’re not socking away $20 a week for the next emergency, so when that next one hits, you repeat the cycle. You’re giving away $200 a year to the credit card companies and forgoing some savings account interest as well.
We’re not even talking about the extra risks of relying on credit cards. What happens if the emergency hits and you’ve already got a hefty balance on your cards? What if the bank lowers your credit limit and then suddenly your transmission falls apart?
None of these risks – and countless others – apply if you simply have a cash emergency fund.
What I Could Have Done Differently
My first mistake was not having a cash emergency fund, of course. This put me up for all kinds of risks, ones that came to a head with my own financial meltdown in early 2006 when I could no longer pay my bills.
The second mistake, tied directly into this mess, was carrying a balance on my credit cards. Credit cards are a great tool, but they’re really only useful if you don’t carry a balance forward from month to month on them. If you start carrying a balance, you’re going to pay dearly for that balance in the form of very, very high interest rates.
Add the two together and you’re running on pure borrowed time, hoping that you don’t ever have more than one or two emergencies at once. Because when that happens, you’re going to find yourself in a bad place, with damaged credit, banks harassing you for their money, and a big helping of added stress in your life.
How You Can Avoid Falling Into this Trap
First, don’t carry a credit card balance. I think credit cards are a fine tool to have if you can use them responsibly, and responsible credit card use means never carrying a balance. How do you do that? Never put anything on that card that you don’t have the money in your checking or savings account to cover.
Second, start building a cash emergency fund. The easiest way to do that is to set up an automatic savings plan. Open a savings account at a particular bank of your choice, then set up an automatic transfer from your checking account to that savings account. $20 a week is a healthy place to start because after a year, you’ll have $1,040 in your account (plus some more thanks to interest). Use that cash when something unexpected gobsmacks you.
The biggest thing, though, is to recognize that emergencies happen – and they happen more often than most people think. Our minds do a fantastic job of making our crazy disorderly lives seem pleasant and ordered. The biggest crisis in the world seems like nothing more than a speed bump after a little bit of time. Allowing yourself to be comforted by this and thus using that comfort as a reason not to build an emergency fund is one of the biggest personal finance mistakes that people make.