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Don’t Rely On Credit As An Emergency Fund

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Countrywide decided to cut off the home equity lines of credit (HELOC) of tens of thousands of people, one of whom was Nina at Queer Cents! For Nina, that HELOC was like an emergency fund – capital that could be accessed if she needed it and existed solely to mitigate any catastrophic situations. However, last week, in an instant, her catastrophic fund was snatched away when Countrywide decided to close her HELOC with very little notice. Luckily for her the HELOC wasn’t her emergency fund, it was actually the backup to the emergency fund, but it underscores the importance of having a actual (non-credit) emergency fund.

Many people use HELOCs as an emergency fund. A HELOC as an emergency fund makes a lot of sense because the interest is tax deductible, making it significantly cheaper than a normal loan. It’s akin to using credit cards as an emergency fund but a little less scary (credit card interest rates are much higher and not tax deductible). Until the other day, I never heard of a lender suddenly closing a HELOC and very rarely do credit cards close accounts. Lenders want you to spend and closing an account makes it much harder for you to spend. So when this does happen, it happens suddenly, unexpectedly, and likely catches you unaware. Ultimately, it’s not a problem if they just closed your Macy’s account and you can’t buy clothes. It is a problem if they just closed your Macy’s account and you can’t make a surprise medical bill payment because it was your emergency “fund.” (it’s an extraordinary scenario but that’s what emergencies often are)

This underscores the importance of having an actual emergency fund, actual dollars in an actual bank account where the principal is protected. A credit card or a HELOC can be a supplemental emergency fund but it shouldn’t your primary. It can handle months 13 and 14 but don’t lean on it for month 1 and 2. You never want your future in the hands of a third party (especially if they are focused solely on their own profit!).

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8 Responses to “Don’t Rely On Credit As An Emergency Fund”

  1. Matt says:

    Nothing beats having a good emergency fund – unfortunately sometimes those are hard to put into place if you’re deep in debt. I can see why people would rely on a credit card as an emergency fund… they pay them down slowly and if something goes wrong they use the card because they don’t have any money to set aside. Not an ideal situation but it gives them some security.

  2. Frugal Dad says:

    I just had to pay about $600 in car repairs, and it was tempting to just charge it, even though I had an emergency fund in place. I think for some spending cash in an emergency is a mental block, because we are worried about not having any for the next emergency. I dutifully handed over my debit card attached to the emergency fund and promised myself to fund it back up to my $1500 goal out of my next paycheck.

  3. Randall says:

    This is surprising. HELOCs use your house as collatoral same as mortgages, so lenders like these (usually). BofA/Countrywide must be going through some SERIOUS re-structuring and risk identification/mitigation steps.

  4. donna jean says:

    I have to admit to using our credit cards as a backup to a meager emergency fund. I know it isn’t the best method, but as we slowly build up our emergency fund it does offer some piece of mind, like Matt says, until I think on how much it’d hurt us in increased payments if we did use it. But then again, thats also part of an emergency — if it was truly needed, then we’d find a way to make it work if savings couldn’t cover it. HELCO’s aren’t an option for us, just a few months into our house and I’m fine with that.

  5. JRich says:

    I’m going to have to go against the grain. I think sometimes its not a bad idea to have credit as your emergency fund.

    1) If you are in cc debt, I think it is stupid to have an emergency fund. So you have $2000 in an emergency fund insted of paying down debt at 20%+ because you are worried that you will have to loan it at 20%+ if you have an emergency. Just doesn’t make mathematical sense.

    Now, this is a little more understandable if your debt is a student loan or soemthing. Even still, every dollar you have in an emergency fund is a dollar that could be working harder if you are paying down debt.

    2) If you are very financially responsible, and at a high savings ratio and bery low expense to incom ratio, you can get away with credit being your emergency fund.

    I am a prime example of this. I saved roughly 35% of my income last year. I have locked long term incetives that stop my employer from downsizing me (not that that is much of a risk anyway). I have a fully funded HSA (over $10k) that would cover any medical emergency. Any smaller expence can be coverred by decreasing savings (cancelling my savings would give me $2500+ per month extra)

    In cases like that, having credit as an emergency fund is just fine.

  6. donna jean says:

    JRich — Emergency funds and credit card debt — what about instances where an emergency comes up that doesn’t take credit cards? Seems like having some sort of fund available, even if you are carrying some debt, would help more in those situations. I guess one could claim that there are cash advances available on credit, but I for one would never touch them. That just seems more like stacking an emergency with a major fiscal-emergency.

    Also, I guess that since my emergency fund isn’t enough to wipe out my debt, then depleting it will save me only a couple dollars a month in interest and leave me constantly worried about what next big thing is lurking.

  7. Tim says:

    the bad thing about relying on credit for an emergency fund is that you are going into debt to do so, which is the reason you want to have an emergency fund in the first place–that is, so you do not need to go into debt in order to finance an emergency.

    second, if you are going to rely on credit for an emergency fund, you really have to take a serious look at accessibility to credit in an emergency. Even if the current credit issue wasn’t happening, would you have been guaranteed a HELOC? That is the problem with credit, is that there is no guarantee that you will have it, that you can get it, and that you can finance it during an emergency. This to me is the single major reason why relying on credit for an emergency is simply bad.

    third, if you are going to rely on credit, people don’t include the new credit expense in their calculations of the emergency fund. You definitely need to account for the expense of the credit like other expenses.

  8. joetaxpayer says:

    JRich – you are in good shape. I think there’s a hump that you are beyond, where you have the job security, and the HSA, and that savings rate. For some, credit as emergency fund just can’t make sense, but you are a good example of when it does. I am in your group, 2 401(k)s my wife and I can tap, a HELOC, and income to pay back whatever we need to borrow.

    Donna – most credit cards alow a cash advance. No one should sleep better having $5000 in the back at 1% interest when they owe $6000 on credit cards at 20%. That’s $1000/yr that can be better utilized.
    JOE


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