Reader Question: I Don't Have Much Savings So Can I Use Unused Credit as an Emergency Fund?

I occasionally get questions from readers and try to answer each one to the best of my ability, but there are some questions that get asked more than others. For these types of questions I like to turn it into a post so that it can help even more people.

One of the questions I get a little more frequently than others has to do with emergency funds and credit cards or lines of credit. We always stress the importance of building up an emergency fund, but it can sometimes take a while to get to that three, six, or eight month target. So, people often wonder if it’s acceptable to work with a relatively small emergency fund while holding on to a few unused credit cards or a line of credit to make up the difference. So, what’s the verdict on credit cards and emergency funds?

Using Credit vs. Savings

Even if you have unused credit available to you in the event of an emergency it’s still vital that you build up a cash emergency fund. While it’s a good idea to have a credit card without a balance out there and ready in case something does come up, this should be an absolute last resort and not even thought of as part of your emergency fund. There are a few reasons why using credit over savings could be harmful.

First, cash is money that you have and credit is money that you don’t have. If something comes up and you have to find some money to pay the bills or other unexpected emergency, if you use cash you’ve saved you’ve immediately satisfied that need. On the other hand, if you pay off that expense with a credit card, you haven’t relieved yourself of that expense. All you’ve done is basically delayed the payment. And for that convenience you’ll be charged interest. So, cash eliminates the emergency, credit just delays it.

Second, you could be making the situation worse by introducing a new monthly expense which comes in the form of the credit card payment. Let’s say you have a $5,000 emergency come up. If you have that money set aside in savings it’s a quick one-time payment and you won’t have to think about it again. But if you are forced to use a credit card to pay that $5,000 you’ve only transferred the emergency from the initial bill to a credit card and will begin with monthly payments. A $5,000 balance on a credit card could easily amount to a $100-$150 monthly minimum payment. If your budget allows, that might not be a problem. But if your emergency extends for very long you could find yourself suddenly in a bigger emergency when you can’t make the minimum payments on that credit card.

Secured vs. Unsecured Debt

Make sure you understand the difference between the two when using credit to get through an emergency. A lot of people tend to treat their home equity loan or home equity line of credit as an emergency fund, but this is a bad idea. This is secured debt, which means the money you borrow is backed by an underlying asset–in this case, your house. When you can’t pay off a secured debt the bank can take the property back.

Just like in the credit card example above, if an emergency comes up such as a job loss and you tap into a home equity line of credit to keep things going for a few months, you’ve essentially just put your house on the hook for your emergency. Now, you not only have a mortgage payment on your house but a home equity loan payment, so what happens if you can’t find a job as quickly as expected? Sooner or later those monthly line of credit payments may be impossible to pay so now your financial emergency just expanded and puts you in a position where you could lose your house.

If you must rely on credit to get through a financial crisis, make sure you tap unsecured debt like credit cards first. Sure, you’ll pay a higher interest rate and may not have as much credit available, but the damage done in the event of a prolonged emergency can be minimized.

Consider Your Options Carefully

It’s ok to temporarily have some available credit out there as an added safety net if a true emergency arises, but it should in no way substitute for actual savings. Just because you have about two months worth of savings set aside and four months worth of expenses available in the form of credit doesn’t mean you have a six month emergency fund. It may be good to know that in a worst case scenario that you have that going for you, but you should still be working to build up the cash in your savings. Don’t stop saving just because you have a little bit saved along with a sizable unused credit line.

Credit can work in a pinch, but don’t get complacent and fall back on your savings. And also make sure your savings is working for you. I know interest rates aren’t as good as they used to be, but you’ll still want to earn a little bit of extra money in the form of interest so stick with a high-yield savings account if you can. Then, make sure you’ve created an automatic savings plan so that you have money going into the account each week, bi-weekly, or monthly. When you put your savings on autopilot you won’t even have to think about it, and before you know it you’ll have enough cash set aside that you won’t even have to think about using credit to get through an emergency.

Author: Jeremy Vohwinkle

My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.