Financial experts often offer conflicting advice, but one thing they all agree on is the need for an emergency fund. Keeping the money in a savings account is usually recommended but what if you don’t have a huge amount of cash to work with?
In that scenario, a credit card or home equity line can act as a stand-in for emergency savings but it’s not a perfect solution. Using credit as an emergency fund is convenient if you’re in a financial jam, but it’s not without certain drawbacks.
When Using a Credit Card for Emergencies Works in Your Favor
Charging an emergency expense to your credit card in lieu of using cash can make sense in the right situation. If you’ve got a card with a 0 percent rate that’s locked in for six months or a year, for example, that gives you plenty of time to pay off the balance without having to worry about paying interest. That’s a cheaper alternative to borrowing from the bank or taking out one of those wallet-gouging payday loans.
It can also benefit you if you’ve got a rewards credit card and you’re charging a pretty sizable expense like a major car repair or a new refrigerator after your old one conks out. When you’re making a purchase of several thousand dollars, you’ll see your reward points or miles shoot right up. You can then turn around and apply those rewards as a statement credit, effectively giving yourself a discount on whatever it was you had to buy.
Why You May Want to Think Twice
While no interest and big rewards are tempting reasons to use your credit card for emergencies, it’s not always the best move. If you’re not able to snag a deal on a low rate, the odds are good that you’re going to be paying a pretty penny in interest unless you can wipe out the balance relatively quickly. If you had to take a cash advance for an emergency, that’ll push the rate even higher and you’ll also be charged a fee for this convenience.
Relying on plastic for emergencies can also be dangerous for your credit score. One of the things lenders look at when evaluating your credit-worthiness is your debt utilization ratio. This is how much you’ve borrowed versus your total credit limit. If you had to max out a card or two to cover an emergency, it can shrink your ratio and make you look like a bigger risk to lenders. Your bank could decide to close your account altogether if you charge a big expense out of the blue, which would hurt your score even more.
Finally, you have to consider how charging an emergency to a credit card would affect your monthly budget. If your minimum payments suddenly skyrocket, that can put unnecessary strain on your budget. When you can’t keep up, you run the risk of defaulting which damages your credit and opens the door to collection actions.
Replacing Your Emergency Fund with a HELOC
When you borrow from your home equity line you’re effectively borrowing from yourself since it’s secured by the value that you’ve accumulated in the property. Compared to a credit cards, home equity lines tend to offer lower interest rates and the terms are generally more flexible. For example, you may be able to stretch it out over 15 or 20 years and only make interest payments during the initial repayment period.
If you’ve managed to build up a lot of equity, a HELOC may offer a lot more borrowing power than a credit card. There are no restrictions on how you can use the money, so you’re covered no matter what kind of emergency crops up. As an added benefit, the interest you pay on a home equity line is tax-deductible, which can help to lower your tax bill or increase your refund. That’s not the case with the interest you pay to a credit card company.
Pitfalls of Using a Home Equity Line for Emergencies
The biggest issue you need to think about when using a home equity line as an emergency fund is what would happen if you couldn’t afford to make the payments. When you default on a credit card, the creditor can sue you and even go as far as garnishing your wages or your bank account but they can’t take your home. If you get behind on your HELOC payments, the bank has the option of initiating foreclosure proceedings to get you to pay up.
If you end up in really dire financial straits, you can wipe out a home equity line by filing bankruptcy but you’re also going to ruin your credit in the process. It’s possible to eliminate a home equity loan in a Chapter 13 filing if you’re upside down in the property but that’s really not a road you want to go down unless you absolutely have to.
So Which Is Better?
Keeping a cash emergency fund in an interest-bearing account is almost always your best option. If you can’t do that, deciding whether to substitute a credit card or HELOC means deciding which one is the lesser of two evils.
A credit card is potentially the more expensive choice but if you’ve got good credit, you should be able to find a zero interest deal. As long as you’re diligent about paying it off, you won’t have to worry about running afoul of the credit card company and there’s also no need to be concerned about losing your home if you can’t pay.
A home equity line, by comparison, typically comes with a lower rate but if it takes you a decade or more to pay it down, you may not be saving yourself anything by going this route. Not only that but some lenders tack on an origination fee for making the line of credit of available. In the end it comes down to running the numbers to see which option is the most cost-effective and is least likely to put you at risk financially.
Have you ever used your credit card in an emergency?
