Having a credit card to use in case of emergencies sounds like a good idea. But many people make the mistake of relying only on the undrawn limit of their credit cards for emergencies. They choose to believe that credit cards alone will be enough for emergencies. But that is not correct.
Credit cards can no doubt be used to make transactions in financial emergencies. It gives you a few weeks time to arrange funds on your own then. But credit card is not a replacement for your actual emergency fund.
If you use your credit card to pay for an emergency and then for some reason, do not have any savings to be able to clear your credit card dues in full, then it can be extremely costly due to the exorbitant interest charges of 30-40% charged by credit cards on unpaid bills.
Suppose there is uninsured medical emergency in the family for which you need to pay Rs 5 lakh immediately. You max out your 2 credit cards and pay up Rs 5 lakh bills. Now you don’t have any dedicated emergency fund as you always thought the emergencies like these could be handled by credit cards. No doubt you paid of the huge bill easily. But eventually, it’s a credit that you took, i.e. a short-term loan. And you have to pay it back when it becomes due in a few weeks time when you next credit card bill is generated. Right? So you will need to find Rs 5 lakh from somewhere to clear the card due in full. Else, you will pay a lot of interest. Had you saved up an emergency fund, it would have come in handy to pay the bill. Isn’t it?
It is for this reason that you should not treat credit card as your emergency fund.
Related Reading – How credit card interest is calculated?
Having an emergency fund is a mainstay of solid financial planning. You might have your long-term investments, health insurance and credit cards that can be used for emergencies.
But still, you must have an emergency fund:
- Credit cards I have explained earlier (you eventually have to pay it back in few days). Also, credit cards may not be accepted at all places. Then what will you do?
- Health insurance might not be sufficient at all times (or at times, uninsured medical expenses at home can cost you a bomb, as I experienced myself during my Covid-19 experience).
- As for dipping into long-term investments for emergencies, that’s not advisable as emergency might come in a bear market when your investments are already down. So you might have to book losses and then liquidate investments to pay for emergencies. In a way, having an emergency fund ensures that your long-term investments remain invested for long-term.
And how big should your emergency fund be?
I am sure you have read a lot about it. Generally quoted rule is having 6 month’s worth of expenses. But think for yourself. Some of you have more dependents, less earning members, jobs in risky sectors, etc. So such people might find having a bigger contingency fund useful. Isn’t it?
One can even consider taking a personal loan to avoid paying high interest on credit card dues (read using personal loan to clear clear credit card dues). But personal loans are cheaper compared to credit cards, but on a standalone basis, even these are costly. So if you have an emergency fund, you won’t need a loan either.
And don’t worry too much time on deciding where to put your emergency fund. Keep it simple and easily accessible. Keep some cash at home, some in savings account and rest in fixed deposits (and/or liquid funds and ultra short duration debt funds).
An emergency fund can be a real lifesaver. It’s like an umbrella. You don’t need it when it’s sunny. But when it rains, it really helps to have the umbrella.
So remember that… a credit card is not an emergency fund.