The emergency fund is popularly regarded as an essential fallback for anyone in pursuit of a stable financial life. Unfortunately, too many people opt to use one of the worst emergency funds available — credit cards.
Personal finance experts offer the general advice that everyone should have an emergency fund to cover surprise expenses — and that credit cards definitely do not qualify as emergency funds.
The money gurus say one thing but the actions of many people defy that core personal finance lesson. Their idea of an emergency fund is a credit card, not cash sitting in a bank account.
It is taboo to advocate using a credit card as a financial backup because interest charges threaten to consumers in debilitating credit card debt. But, we cannot deny the reasons supporting credit cards as the most common emergency funds.
Here’s why the most popular emergency fund is a credit card:
How Big Should an Emergency Fund Be?
It should be three months worth of expenses. No, twelve months worth of expenses. No, it should be at least $1,000. How much is enough to be “safe”?
The right amount for an emergency fund is impossible to determine because it can vary greatly depending on every person’s unique situation. A young college graduate will find extreme comfort with a cash reserve of $1,000, but a couple with two children may find $20,000 to be the bare minimum for an emergency fund.
In the event that emergency fund is not enough to cover an emergency, credit cards often inherit that role.
Establishing an Emergency Fund is No Small Feat
For the paycheck-to-paycheck population, squirreling enough to build an emergency fund feels like a steep uphill battle.
Even after finding the ‘right’ number, establishing an emergency fund is a test of mental resolve and self-control. If paying down $15,000 worth of credit card debt was difficult, building a backup fund may be harder because it’s something you want to do — a choice — unlike required credit card payments.
For someone who is left with a small amount of discretionary income after expenses, even a monthly automatic transfer of $25 leaves little breathing room – which becomes discouraging over the long run. Also, one must resist the temptation to spend a growing emergency fund on an unnecessary car upgrade or extravagant trip.
The Cost of Opportunity
Those who have the ability to establish a sizable emergency fund don’t necessarily want to do so. They feel that an extra $10,000 is better off in the stock market or other more profitable ventures rather than having idle cash sitting a savings account earning paltry interest (and to get slapped with taxes).
Currently, high-yield savings accounts offer returns barely beating 1% APY while the stock market has yielded double-digit returns in the past year. Risk-tolerant individuals would opt for the opportunity to make higher profits as opposed to guaranteed super-low returns.
If something happens, their plan is to use a credit card to pay the expenses and cover the bill by pulling their money out from investments.
Accessibility and Liquidity
The positive traits of credit cards are the exact reasons that they are so dangerous for irresponsible consumers.
Credit cards are easily accessible and speedy, which makes a great fit for spontaneous, unexpected expenses. Additionally, a credit card doesn’t compromise your liquidity – the debt can be paid off over time while cash is available for when credit isn’t accepted.
Even diligent savers will use their credit cards during an emergency, deplete their cash reserves to pay the bills, and replenish their emergency fund.
Simon Zhen is the Wednesday columnist and regular journalist for MyBankTracker.com. He concentrates on personal finance and bank rates, products, and services. Follow him on the MyBankTracker.com Community or on Twitter @Simon Zhen.