Using Credit as an Emergency Fund is a Bad Idea

Not too long ago my neighbor needed a new water heater. After it was installed, we went on one of our daily walks and she moaned about the expense and hassle.

“Well,” I said, “at least you covered it out of your emergency fund, right?” I’ve heard her speak about their emergency fund so I simply assumed that the replacement water heater had been paid for using emergency cash.

“Oh, sure. We put it on the HELOC.”

“Huh? I thought you had an emergency fund,” I said.

“We do. That’s what the HELOC is for.”

Oh, man, I thought, seeing the huge risks and holes in this plan. Turns out the emergency fund I’d heard her speak of before wasn’t made from cash, as I’d assumed (yet again, this proves the wisdom of the old adage about assuming). Her emergency fund is made up of credit.

She’s not the only one. I’ve heard of many people who use credit cards, HELOCS, and other loans as emergency funds rather than saving up cash. Their thinking goes that those lines of credit are just as good as cash and easier to access in an emergency when compared to transferring money out of a savings account or cashing in a CD or stocks. Many of them are certain that they will be able to pay if off before paying much, if any, interest. Some simply can’t be bothered to save up the cash, while others use this method because they want to do other things with their cash like invest, buy real estate, or simply spend on things that are more fun.

Using credit as an emergency fund carries a few big risks, however. First, if you’re using a HELOC you’re essentially putting your house on the line. A home equity line of credit is guaranteed by your home so if you can’t pay back the loan, the bank can take your house. If my neighbor can’t pay for that water heater, she could lose her house.

Second, credit lines require that you pay interest. While a HELOC might be low interest, you’re still paying interest. And credit cards can have interest rates as high as thirty percent or more. If you’re using payday loans for an emergency fund, you could easily be looking at a one-hundred percent interest rate. If you don’t pay these lines of credit off immediately, you’ll end up paying far more in interest than the original emergency would have cost.

Many people have found themselves hopelessly in debt using the credit as emergency fund strategy. They start with the best of intentions. They swear to pay it off right away and not to use it for anything other than an emergency. But things go wrong. An emergency happens around the holidays and that credit card gets tapped for holiday spending in addition to the emergency. Or more than one thing goes wrong at once, meaning that you have to put more on the credit line than you intended. It doesn’t get completely paid off in the first cycle and so the interest starts accruing. Now the payments are higher than you planned. And on it goes until you are deeply in debt, all from one emergency that could have been handled, in cash, with a regular emergency fund.

Using credit for an emergency fund only works for those who are disciplined enough to pay it off immediately, every single time. This usually means once of two things: Either you have a very high income that affords you enough cash to be able to pay it off before the interest begins, or you have other assets such as stocks that you can liquidate to pay off the debt. For most people, though, using credit as an emergency fund is a strategy to avoid. It may be painful and require sacrifice in the short term, but you’re better off stashing some emergency cash in a savings account.

(Photo courtesy of eliazar)