CNN's Walter Updegrave fielded a question this weekend which, simply, sort of shocked me. A reader wanted to know if he and his wife should temporarily stop paying the full balance on their credit cards in order to build up an emergency fund. Is this really an option that some people are considering?
What To Do!
As Walter states, the only thing you should be doing if you don't have an emergency fund is planning how to start and fund one. While financial planners differ on whether to start one when you already have a good deal of credit card debt (for example, here's Suze Orman tweeting with fellow blogger Matt Jabs), there should be near complete unanimity that if you are current on your credit card balances it's not worth going into debt to start one! Correct me wrong, because, of course, I'm not a financial planner and you should consult one if you are thinking of this sort of thing!
Walter gives the only reasonable answer to this question: no, do not only pay your minimum balance to form an emergency fund. Instead, you should work at reducing your expenses in order to free up some cash to put into an emergency fund. This can be through nickel-and-diming yourself through an intense budget or concentrating on big-ticket items. There is plenty of advice out there on saving money- read it before you start trying to hack your way into an emergency fund. There are no shortcuts.
Proof of No Shortcuts
Let's say you've got a credit card with an APR of 14.74% (APR means you're charged 1.228% a month). Your goal is to have an emergency fund of $6,000. You normally charge $1500 a month on your card, and the minimum payment is 4% of the outstanding balance. Your bank account yields .083% a month, for an APR of 1% and an APY of 1.0006%. Using these assumptions, we can make a sweet graph of how much worse off your finances will be in a year! (Note: we're simplifying things a bit because interest will change based upon the day you pay the credit card bill or deposit into the bank)
First, the baseline scenario. It's not interesting since you won't have an emergency fund at the end of the year, but you also won't have new debt. Look:
Baseline Scenario
Now, let's look at your weird monthly compounding credit card and bank account, and see how it affects your end of year numbers! Take a look here:
Minimum Payment Method
The numbers aren't super important for this example, but the illustration is: your credit card balance increases faster than your emergency fund balance. With the numbers and crazy assumptions we used, you're $1,245.39 worse off after a year. If math is used as an argument for using this 'minimum credit card payment' method of starting an emergency fund, this can only mean the APY on your savings account is more than your credit card charges on its balance. Basically, the only legitimate arguments for paying off any debt (other than the one I just stated) is either grounded in psychological or "your credit cards will soon be canceled" grounds. In many cases, if you are paying off your balances monthly, you are better off using your credit card in the emergency situations. Both emergency funds and credit cards are liquidity tools. If you want the fund, make the sacrifices necessary to save for it, don't try this particular shortcut.
