The “emergency fund” is the one of the most confusing ideas in personal finance, because it means different things depending on the guru you talk to. For some people, it’s a contingency fund, to cover car repairs or last-minute babysitting needs. But those aren’t emergencies — cars just break down sometimes and babies sometimes need sitting! While you should certainly save money to cover those expenses, I don’t feel that the word “emergency” is doing any work there.
In my view, an emergency fund is for covering really exceptional situations, like eviction from an apartment, loss of a job, or a temporary disability. In those situations, you’ll need immediate access to cash in order to cover your expenses while you get your financial situation back on track.
Quick Tip: When you assess your financial situation — saving vs. paying off your credit cards, it’s important to check your credit score, in case you’d like to consolidate some of that debt into a low-interest credit card or take out a personal loan. See your free credit score on Credit Sesame.
And that raises the question: if you’re carrying high-interest credit card balances month-to-month, should you prioritize paying down those balances or contributing to an emergency fund in case of sudden financial hardship?
Credit card interest rates will always be higher than a savings account
If you are carrying high-interest credit card balances while saving cash in an account paying almost nothing in interest, the peace of mind you’re buying is expensive. Very expensive.
Say you have a $10,000 balance on a credit card with an annual percentage rate (APR) of 15 percent. With $3,333 in monthly expenses, you follow the widely acknowledged personal finance advice of saving three months’ worth of expenses (the same $10,000) in an online savings account (such as Ally Bank or Radius), which pays around 1 percent APY per year.
The peace of mind you get from your emergency fund is costing you $1,400 per year — this is the 14-percentage-point difference between the 15 percent credit card interest and a 1 percent interest rate at an online bank. And that money isn’t going to pay down your debt — think of it as the amount you’re paying your credit card company to “keep your balance” on your credit cards month after month.
The move should make: Pay off your credit card balance and, based on the example, you’ll have $1,400 per year in extra money to cushion your finances.
Think of paying off credit card debt as one of the best investments you can make
If a stock broker called you offering a hot new investment with a guaranteed 15 percent annual rate of return, you’d think he was a con artist (and you’d be right). In today’s interest rate environment, if you’re willing to lock up your money for five years in a certificate of deposit, you might be able to earn 2 percent per year on your savings.
But there really is an investment you can make with a 15 percent annual return: simply paying off your high-interest credit card debt! Every dollar of principle you pay off will earn you 15 cents in interest you would have otherwise paid to the bank.
The key point here is that when you make a credit card payment, you’re not “spending” your savings: you’ve already spent the money! Rather, you’re investing your savings in one of the highest-return investment vehicles imaginable.
Retirement needs to be funded too
Once you’re in the mindset that paying off credit card balances is a smart, simple investment strategy, you might be eager to get started, so I want to mention a few exceptions to the rule that credit card payments are the best investment strategy.
If your employer matches contributions to a workplace savings program like a 401(k), 403(b) or 457(b) plan, you’ll always want to maximize those matched contributions first. Even if your employer only matches every second dollar in contributions, you’re still earning an immediate 50 percent return on your savings — even better than paying off credit card balances.
Likewise, if your income qualifies you for the Retirement Savings Contribution tax credit, you may also want to consider making the maximum qualifying contribution to a Roth or traditional IRA. In addition to the immediate savings on your income taxes, you’ll also enjoy tax-free capital gains on investments housed in a Roth IRA.
The move you should make: Contribute to your 401(k) or max out your IRA
If you don’t have the cash, you need an emergency plan
All of this may leave you wondering: if you use your savings to pay down credit cards, what do you do in the case of an actual emergency? After all, saving money on credit card interest doesn’t do anything to keep you from getting evicted or losing a job, or worse.
My answer is that rather than an emergency fund, everyone should have an emergency plan, especially if it’s difficult to save money and a real emergency should arise.
For example, most credit cards will allow you to take a cash advance out against your credit line.
It’s true that the banks charge a lot for these cash advances — typically around 5 percent of the amount of the advance plus any interest charges that accrue. But three months’ of interest, plus a 5 percent flat fee ends up being 8.75 percent — far lower than the 15 percent you might be paying on your existing balances.
Remember, the goal is not have to use a cash advance on your credit cards for an emergency, but if you really need the money and don’t have the cash, it’s worth it to have a plan in place. This means doing things like taking a look at how much the cash advance fees are for your credit cards and figuring out how much it would run you if you needed, say, $2,000.
If you still need time to pay off purchases, use a low interest rate credit card
Finally, it’s worth mentioning that if you aren’t able to pay off your credit cards immediately, transferring your balances to credit cards with low introductory interest rates on balance transfers can potentially save you money.
Just don’t let balance transfers become an exercise in can-kicking, your first priority should still be to get your revolving credit card balances as low as possible, as fast as possible!
Disclaimer: The article and information provided here is for informational purposes only and is not intended as a substitute for professional advice.