Every family should have an emergency fund. In fact, some financial planning gurus suggest that an emergency fund should contain 3-6 months of income.
Why? Stuff happens! Cars break, furnaces break, dishwashers break we are surrounded by convenience items that are pretty reliable, but there are just too many of them. Additionally, people lose jobs even in good times, and anyone can get sick and miss work. The bills dont stop when the income stops.
Credit cards are one way some people handle emergency expenses. When something happened, you just put down the card and paid it back later.
Unfortunately, as credit requirements have gotten tougher, that may not work. Banks have become more willing to reduce lines of credit or cancel cards. Even if you can get credit, it can be expensive.
The cost of credit has been high for a long time. Lets do a quick example:
- If you carry a balance of $5,000 and pay 2% interest each month, you are paying $100 a month without reducing your balance. That is $1200 a year. If you keep doing that for 5 years, you have paid $6000 of interest for borrowing $5000.
- In case you have a moment of feeling bad for banks taking write-offs on credit card loans, you might remember how much interest they earned before they couldnt get all of the principal back. In this example, if they only got half of the money back at the end of five years, the bank still received $8500 on a $5000 loan. It takes some imagination to call that a loss!
Over the past decade, many people have gotten rid of credit card debt by rolling it into a home mortgage or a home equity line of credit. This makes sense from two points of view.
- First, you can get a lower interest rate for a loan that is secured by your house.
- Second, the interest paid can be deductible for tax purposes.
- However, with the decline in home values, this option is not available for many people.
Lets look at the $5000 loan a different way. Suppose we plan to pay back the loan over three years.
- If we have to pay 2% interest per month, we will have to make payments of $196 at the end of each month to pay off the balance.
- If we had saved enough in an emergency fund to borrow the money from our savings, the cost would have been much lower.
- At current rates, you might only lose 1% interest on the funds you take from your account. And that is an annual rate of interest, not a monthly rate!
- At 1%, the payback would be only $141 a month or $55 a month less.
- Over three years, that adds up to nearly $2000 of reduced costs.
- That is assuming that you make every payment on time and dont make any additional charges on the card.
- The normal free interest if the balance is paid on time each month is lost while you are carrying a balance. None of this happens if you use your emergency funds.
Credit cards are a way of life today. They are not all that expensive if you pay them off regularly. But, using them as a substitute for having an emergency fund can be very expensive.
If you are setting your sights on paying off your debt, dont stop there. Keep going until you build up a fund to avoid getting back into debt in the future.
Featured Blogger Matt Easley is Vice President of Life Products at Allstate Life Insurance Company. His views are his own and do not necessarily represent the positions, strategies, or opinions of Allstate.