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It can be tempting to use your credit card when unexpected expenses put a strain on your wallet. However, you should avoid using a credit card to cover costs when faced with a financial emergency. If you use your card and can't pay off the expense quickly, you could end up paying expensive interest charges over months or years.
Instead of turning to your credit card in a pinch, lay the groundwork now to prepare for a financial emergency.
Risks of Using Credit Cards for Emergencies
Sometimes, parents entrust their teens with a credit card, to use "only for emergencies." As adults, we tend to utilize our credit cards a little differently. But when faced with an unexpected bill, your credit card shouldn't be your default payment method. A few major pitfalls include:
Taking on High-Interest Debt
Credit cards often come with high interest rates. Even if you have a credit card with a low- or no-interest promotional period, eventually, the standard annual percentage rate (APR) kicks in. Interest payments can add up over time, greatly increasing the cost of the original expense. In addition, having to pay off the emergency expense could put you in a difficult position if another unexpected expense were to arise.
Potential Damage to Your Credit
It's one thing if you use a credit card and then immediately pay off the balance. But, if you use your credit card to cover an emergency expense and then don't have the money to pay the bill, you could damage your credit.
And, even if you make consistent on-time payments, the expense might eat up a large enough portion of your available credit to skew your credit utilization ratio, or amount of available credit you're using. It's recommended you maintain a utilization ratio under 30%; a purchase that tips your credit card usage above that percentage can negatively affect your credit.
Risk of Overspending
Falling back on swiping for a big purchase, even an emergency expense, can enable a dangerous habit: overspending.
It can seem harmless enough at first, but the seeming ease with which your piece of plastic puts off payments on a purchase can lead to a slippery slope. Even one big purchase charged to a card can accrue a significant amount of additional debt, and you may find yourself charging more and more purchases as you are forced to put your cash toward your credit card bill.
Lost Access to Future Credit
Using a credit card for emergency expenses poses another serious risk: the possibility of limiting your future credit access. This could happen in a couple of key ways:
- Your credit utilization rate goes up. As mentioned, a higher utilization rate could lower your credit score, making you less appealing to lenders.
- You max out your credit limit. Credit utilization rate aside, maxing out a credit card is bad news. Running up your balance can cause your card issuer to lower your credit limit and possibly even cancel your card. Plus, you may risk fees for going over your limit, depending on your card company's policies.
Difficulty Building Up an Emergency Fund
Similar to your inherent risk of overspending when you charge an emergency expense, your card use can eat into your ability to save a proper emergency fund for future unfortunate situations. You may have a significantly more difficult time setting money aside consistently to build an emergency fund if you're stuck with a large credit card bill to pay.
How to Build an Emergency Fund
An emergency fund is savings set aside exclusively to cover unforeseen financial circumstances. Having an emergency fund in place can give you peace of mind and reduce the need to go into debt when there's an unexpected lapse in income, a big expense like emergency medical bills, home repairs, job loss—or many other situations that could present financial challenges.
To start your emergency fund, begin by examining your budget. Determine how much you can contribute to your emergency account. The rule of thumb is to save enough to pay for three to six months of expenses. If this seems impossible, even adding enough to get to $1,000 could help in many situations. Then build from there.
Once you've set your emergency fund goal, make your contributions part of your payday routine and automate the transfers. From there, send that money to a dedicated account that doesn't get touched for any other expenses.
Once you've saved up to your goal, you can reduce your contributions, but it's wise to keep at least a small amount flowing into your emergency account. The idea is to have access to enough saved money to get you through a tough time, so regularly adding to your fund pads your efforts.
Where to Keep an Emergency Fund
First, let's get the wrong places out of the way. Here's where not to stash your emergency fund:
- In a piggy bank
- Under the mattress
- In your wallet
Setting aside money for your emergency fund is important, but you need to keep your money somewhere that's both safe and smart. That means:
- Don't tuck it away somewhere unreachable. After all, emergencies typically don't afford you much extra time to get your hands on the needed cash. This means keeping your emergency fund in a separate bank account rather than funneling it into an investment account, for example.
- Keep your emergency fund as separate, dedicated savings. Don't count on yourself to mentally separate your emergency funds if you keep them in the checking account you use to pay other bills, for example. This makes it too tempting to think you have more money to spend than you actually do and risks you spending your emergency fund for non-emergencies.
- Choose the right type of account to grow your emergency stash. A high-yield savings account can steadily add to your funds with a higher annual percentage yield, or APY, than you'd get in a traditional savings account. For example, an account with a 2% APY would turn $5,000 into $5,100 after one year without any extra contributions on your part. You might also consider other options, like short-term CDs or money market accounts to keep your emergency fund safe, growing and adequately on hand.
The Bottom Line
If you don't have an emergency fund yet, don't fret. You have options to tackle whatever you face―but the sooner you implement a plan to save up your emergency fund, the better. Building up emergency savings will help you weather storms without going into debt by using a credit card.
And if you have a larger expense that you can't cover with your emergency fund, keep your credit in good shape should you need to apply for a personal loan, for example. Regularly check your credit report and credit score for free with Experian, and make moves to improve your score if necessary.