Credit cards are useful, but an emergency fund they ain’t

Always keep your emergency fund as separate and dedicated savings. Don't rely on yourself to mentally keep it separate from other savings.

The idea of having an emergency fund is fundamentally a solid one. If you have about six months’ worth of basic expenses in an emergency fund, then you can take care of a lot of unexpected events like temporary job/income loss, uninsured medical expenses, unplanned repairs, travel expenses, etc.

Sadly, a vast majority of Indians don’t have such a fund. And many of them, mostly the younger generation, who now have credit cards, feel that these cards will be handy in an emergency. And that is correct to an extent. Having a credit card to use in emergencies sounds like a good idea. But many make the mistake of believing that credit cards alone will be sufficient backup for emergencies. And that is wrong.

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Credit cards cannot and should not be a replacement for having a separate emergency fund.

Not for emergencies

No doubt, credit cards come in handy to make payments in financial emergencies. But after a few weeks’ time, when the bill comes, you eventually will have to find money to pay back the dues.

And if you can’t pay in full, then you will incur heavy interest of 36-40 percent per annum on those outstanding dues. So, what may seem like a quick fix initially, can very soon end up feeling like a millstone around your neck, as far as your finances are concerned.

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For a moment, let’s assume that you use a credit card in an emergency, and then start paying back your dues gradually. Now what will you do if, God forbid, another emergency comes up soon after? I know this sounds like a worst-case pessimistic view. But still, give it a thought and you will understand why many households are ruined financially. Remember, emergencies don’t wait for you to have an emergency fund.

Massive interest payout

Let’s take an example here — suppose you don’t have any emergency savings. Now, suddenly, you have to pay Rs 3.5 lakh for an uninsured medical emergency in the family. You pay it using your credit card. You don’t have a dedicated emergency fund as you always thought emergencies like these could easily be handled using credit cards. Now, when the bill comes, you have to pay it back. So, you will need to find Rs 3.5 lakh from somewhere to clear the card due in full. Else, you will pay a lot of interest. Had you set aside some savings in an emergency fund earlier, it would have come in really handy to clear the card bill.

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It is for this reason that you should not treat credit cards as your emergency fund. Credit cards are just a mode of payment not a permanent source of funds. You have to pay back what you borrow using your cards.

But what if you have to use a credit card for an emergency and you also don’t have an emergency fund?

In that case, once you have made a large emergency transaction using your credit card (and you don’t have savings or emergency funds to repay it), you should start exploring other options. One such option is taking a personal loan. These are costly loans but still come at much lower rates (10-15%) than credit card interest rates (35-40%).

A relative of mine did not maintain an emergency fund. He said he already had long-term equity mutual fund investments which he could liquidate if needed. But what sounds fine in theory may backfire in reality. Dipping into long-term investments for emergencies is not advisable as an emergency might come in a falling market when the value of your investments is already down. So, one may have to book losses and liquidate investments to pay for emergencies. And that is not what anyone would want. If you look at it from another perspective, an emergency fund ensures that your long-term investments remain invested for the long term, without any unplanned liquidations.

Set up an emergency fund

If you don’t have one, do read about how to start an emergency fund. Generally, the consensus is that the corpus should cover about six months’ expenses.

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But this is just a thumb rule. Different people in different circumstances will need different sizes of emergency funds. So, those who have more dependents, fewer earning members, jobs in risky sectors, erratic business income, etc. might need a bigger emergency fund.

And one last thing. Always keep your emergency fund as separate and dedicated savings. Don't rely on yourself to mentally keep it separate from other savings. If you do that, you might be tempted to dip into your emergency fund for non-essential, non-emergency expenses as well.