Credit card for emergency fund: Is it a smart choice? Find out here
An emergency fund helps mitigate a financial emergency. It can be 3 to 6 months of monthly expenses. It is not prudent to rely on credit cards for emergency fund purposes. In the long run, you should build and maintain a separate emergency fund.
Financial emergencies are something that can strike at any time. While we cannot prevent them, what we can do is stay prepared with an emergency fund and cushion their financial impact. In this article, we will understand what an emergency fund is, how much it should be, and whether you should rely on your credit card for an emergency fund.
What is an emergency fund?
An emergency fund is a financial fund that can help an individual cope with an unexpected financial emergency. It is a risk mitigation tool for a financial emergency. Some scenarios where an emergency fund can come to the rescue include:
- An individual loses their job, or a self-employed individual loses a client that contributes a significant percentage of the monthly income.
- There is a delay in receiving the salary, or a self-employed individual faces a delay in receiving a payment from the client.
- There is a salary cut, or a self-employed individual gets less monthly work from the client that contributes a decent percentage of the monthly income.
- There is a medical emergency wherein an individual or a family member gets hospitalised, and there is no health insurance, or the insurance cover is inadequate.
- Funds requirement in any other situation other than a regular one.
How much money should one have in an emergency fund?
The amount that an individual should have in an emergency fund will depend on their situation. Some of the scenarios include the following.
- An individual has a stable job in a reputed organisation doing well financially or has a PSU/State/Central Government job. In such a scenario, if your financial situation is stable, an emergency fund with three months of expenses may be considered. If your financial situation is not stable, an emergency fund with six months of expenses may be considered.
- An individual is working with a company that is not doing well financially, or the individual is surviving on a project-to-project basis. In such a situation, an emergency fund with six months of expenses may be considered. For example, airline companies are vulnerable to high fuel prices. If the prices spike, there may be huge losses, resulting in salary delays, salary cuts, or even job losses. Similarly, some industries, like the hotel or the metal industry, are cyclical in nature. When the economic cycle is down, it can result in salary cuts or job losses.
- An individual is self-employed or running a business wherein the monthly income varies. In some months, the cash flows may be good; in others, the cash flows may be less than required. In such a situation, an emergency fund with six months of expenses may be considered.
So, the amount you should have in your emergency fund will depend on various factors. Some of these include your profession (salaried or self-employed), your company’s financial situation, your own financial situation, etc. If you feel, you can maintain some additional money in an emergency fund than optimum if that gives you peace of mind.
Should you use your credit card as an emergency fund?
Some people rely on their credit card(s) during financial emergency situations. It is not the most prudent thing to do. Suppose, you are a salaried individual with a Rs. 50,000 monthly salary and have a credit card with a Rs. 2.5 lakhs credit limit. There is a financial emergency for which you swiped your credit card for Rs. 2 lakhs. Now, while the credit card helped you overcome the emergency situation, what if you don’t have the Rs. 2 lakhs to pay when the credit card monthly bill is generated?
Will you pay some amount and carry forward the balance? In such a situation, you will have to pay a 3.00% to 3.50% monthly interest rate (36.00% to 42.00% annual interest rate). Credit cards are one of the most expensive loans, if the outstanding is not paid before or by the due date. You may have to convert the outstanding balance into easy on the pocket EMIs or avail of a personal loan to pay the credit card outstanding. These options also come with costs like processing fees, interest rate in the 10 to 20% p.a. range, foreclosure charges (if opted for foreclosure), etc.
The bank can reduce the credit limit on your credit card at any time. Sometimes, a situation may arise where you have to close the credit card. In such a scenario, without an emergency fund, you will be left without any financial source to rely on during a financial emergency. Hence, it is always a good idea to have a separate emergency fund rather than relying on a credit card for it.
Combining credit card benefits with an emergency fund
When you have a separate emergency fund, you can use your credit card to pay initially. Using the credit card will give you benefits like a 50-day credit period, reward points, achieving milestones (if any), meeting spend eligibility criteria to unlock airport lounge access, fulfilling spend criteria for annual fee reversal, etc. When the monthly bill is generated, you can use the money from the emergency fund to pay the credit card bill.
How to build an emergency fund?
If you still don’t have an emergency fund, you must start building one immediately. Till you build an emergency fund, in the short term, you may rely on your credit card if there is an emergency. However, in the long run, you must have a separate emergency fund.
The first step to building an emergency fund is to evaluate the amount you need to have in your emergency fund. The next step is to decide the timeline in which you want to build an emergency fund. For example, suppose your monthly expenses are Rs. 40,000, and you want to build an emergency fund with Rs. 1,20,000 in one year. In this case, you can set aside Rs. 10,000 per month in a separate savings account.
You can automate the process by opening a one-year recurring deposit with Rs. 10,000 monthly contributions. On maturity, you can transfer the entire principal (Rs. 1,20,000) and interest to a separate savings account. You should always maintain your emergency fund money in a separate savings account instead of your regular savings account. The other option is to start a systematic investment plan (SIP) in a low-risk mutual fund like a liquid fund. Once the emergency fund amount has been accumulated, you can pause the SIP and maintain the money in the liquid fund.
How to maintain the emergency fund?
Whenever the money from an emergency fund is utilised, it must be replenished within a reasonable period. The process for replenishment can be similar to the process for building the emergency fund explained above.
Building and maintaining the emergency fund is not a one-time process. You should review the emergency fund amount requirement regularly. Certain life events may require an increase in the emergency fund amount. Some of these include:
- An individual has left a stable job at a well-established company and joined a start-up, or started their own business.
- An individual has got married or has taken a big loan like a home loan
- The spouse has left the job or taken a break after becoming a parent, and the family is now running on a single income
- An individual or a family member has been diagnosed with an illness that requires frequent doctor visits, diagnostic tests, and ongoing medicines that are not covered under health insurance.
Even in the absence of any of the above events, over a period of time, your monthly expenses will go up due to inflation and lifestyle upgradation. In such a scenario, you need to review your emergency fund regularly and increase it as appropriate.
Build and maintain a separate emergency fund: Don’t rely on credit cards
We have discussed the various scenarios in which an emergency fund is required and how much money an individual should have in an emergency fund. If you don’t have an emergency fund, you must start building it immediately. While you are building it, credit cards can be your stop-gap solution. While credit cards have their own features and benefits, they cannot be a substitute for an emergency fund.
In the long run, having a separate emergency fund is prudent. As and when it is utilised, it should be replenished at the earliest. One should review their emergency fund regularly and increase it as appropriate.
Gopal Gidwani is a freelance personal finance content writer with 15+ years of experience. He can be reached at LinkedIn.
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