3 Reasons Credit Cards Make a Lousy Emergency Fund

Last Updated Mar 30, 2011 10:13 AM EDT

The IMF recently concluded that many of the world's developed nations are tapped out and would be unable to bear the costs of another disaster like the tsunami and nuclear meltdown in Japan. No kidding. Their emergency funds are exhausted and so is their borrowing capacity.

That makes these nations (Japan, Greece, Italy, Portugal and Iceland) and other governments close to the breaking point (the U.S., U.K., Ireland and Spain) a lot like many individual households -- and it points up the perils of relying on credit in an emergency. What if no one will lend?

There is a reasonable debate as to what constitutes a healthy emergency fund and how families should create one. In general, experts agree that something close to six months of living expenses tucked away in a safe, interest bearing account to be tapped for a major household repair, interruption in income or other emergency is a safety net worth having.

But Dave Ramsay has argued that $1,000 in a cash account is sufficient to cover most unforeseen expenses. Stop there and pay off your credit cards before further building the emergency fund, he says. Others argue you should pay off your credit cards and allow for contributions to your retirement account before allocating assets to a rainy day fund. That way you cut your interest expense and prepare for your future, and still have the option of using the cards again if you run into trouble.

These strategies, though, really just acknowledge the difficulty of saving. It's not easy to stash away, say, $5,000 in an account that pays a measly 2% or 3% and dedicate it to emergency expenses you hope will never materialize. But before you talk yourself into the credit-as-emergency-fund approach, consider these three pitfalls:

  • You may not be able to borrow as planned This is a real concern. It's the one that Japan and other nations are coming to grips with right now -- potentially no lenders. When you pay down a credit card you run the risk that the bank will reduce your credit limit or cancel your card or line of credit altogether, especially if you are experiencing financial problems that show up on a credit report. Yes, you've paid off a debt. But now you have no money when the furnace burns out.
  • You will compound your problems The whole point of having an emergency fund is so that you don't have to go further in debt when trouble strikes. The interest on credit cards is high, and if you can't make the full payment at the end of the month your debt grows and so do your headaches. Instead of replenishing the cash in a true emergency fund you end up paying more interest.
  • Your definition of emergency will expand Credit cards make spending easier. If you carry your emergency fund around on plastic you will find emergencies everywhere -- the new cell phone that makes you more productive, the gourmet take-out because you don't have time to cook, the new washing machine even though the old one could be repaired. Unless you are extremely well disciplined, it just happens that way.
Relying on credit for your emergencies is the best plan only when it is the only plan available to you.

Photo courtesy Flickr user jdhancock
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  • Dan Kadlec

    Daniel J. Kadlec is an author and journalist whose work appears regularly in Time and Money magazines. He is the former editor of Time’s Generations section, which was written and edited for boomers. Kadlec came to Time from USA Today, where he was the creator and author of the daily column Street Talk, which anchored the newspaper's business coverage. He has co-written three books, including, most recently, With Purpose: Going from Success to Significance in Work and Life. He has won a New York Press Club award and a National Headliner Award for columns on the economy and investing.