I often meet with clients who are using credit cards to fund their daily life. With no money in savings credit cards have come through for them time and time again in emergencies. Their reluctance to get off credit is understandable. It’s their friend. They know they can count on it. It’s possible they have never had money in savings and credit has been their life line since they can remember.
Credit is their crutch.
I understand that. Their habit is to use credit when they get in a pinch. If they get into some financial trouble they reach for the credit card. Their brain is not trained to reach for the money in savings. They’ve never had money in savings. Or maybe they’ve tried in the past and the money was quickly spent and never replaced. They learned their savings isn’t always there for them, but credit is. There is always someone willing to let you borrow money, no matter how bad your credit is.
You can think of your savings account like your own personal credit card. If you have $1,000 in an emergency fund, it’s like having a prepaid credit card of $1,000. There for you when you need it.
If you are working a debt snowball (paying minimum payments on all debts except for the one with the lowest balance) then your debt might look something like this:
Credit card #1: $5,500
Credit card #2: $7,00
Credit card #3: $12,500
With your $1,000 baby emergency fund in place you are sending all your extra money to credit card #1, let’s say you are sending $500 per month above the minimum payment. If an emergency comes up can use the money from your Bank of YOU credit card (your emergency fund) to cover it. Let’s say it was $400. So now your debt snowball looks like this
Bank of YOU: $400
Credit card #1: $5,500
Credit card #2: $7,00
Credit card #3: $12,500
The Bank of YOU card is always in the number one spot. In our debt snowball you have an extra $500 per month that you are paying towards your debt. So you would send $400 to the Bank of YOU card and $100 to Credit card #1. The Bank of YOU card would be paid off and you could continue on with your debt snowball.
With a small emergency fund you are putting a barrier between you and life. If you have a $1,000 in savings and are sending $500 as extra debt payments you can actually absorb a $1,500 mishap before you have to borrow. As you start to pay off your debt the amount are sending extra grows. This serves two purposes. It gets the debt paid off more quickly but it also allows you to overcome larger and larger emergencies without taking on additional debt.
Once your debt is paid off you can grow the credit limit on the Bank of YOU card. You can build that up to six months of living expenses. If you have to “borrow” from the Bank of YOU then you still should back it back as soon as possible.
Once your Bank of YOU card is fully funded and prepared to support you for up to six months if necessary you are free to start building real wealth.
It seems like it would be difficult for someone with that much credit card debt to put away $1000 on the side, doesn’t it?
I agree with Tyler. I just don’t see someone in this much debt being willing to sit on that much cash as an emergency fund. Most people are either in a savings mentality or a paying off debt mentality. They would view that $1000 as $x amount of interest they are still paying by not putting that towards their debt. Then again, they have to learn how to rely less on credit somehow. If the extra interest changes the way they think about credit, it would be worthwhile.
Well, there are a lot of things that people with that much debt have a hard time doing hence their financial predicament. Haha!
BUT, what Ashley is essentially talking about here is having an emergency fund instead of using credit to fund life’s little problems. That is one of the most crucial elements to changing financial direction so I’m a little confused by your questions.
Are you both saying that someone with debt isn’t going to think it’s important to have an emergency fund so they should just accept that or are you saying that they should immediately start throwing extra money at their debt without having a backup emergency fund?
If everyone took this kind of an approach there would be lots of people, including myself that would have never become debt free. We had $26K in debt and we saved not $1,000 but $2,000 before we started paying down our debt. It’s a part of the process and something that made paying off our debt so much easier.
How else are you going to effectively pay off debt if every time you turn around you are having to put more on a credit card because you have no other option when an emergency arises?
Just curious as to what you guys mean. 😀
I’m definitely not a debt recovery expert. So my comment was just based on my own logic and not on any actual experience in getting out of debt. I’m sure with the experience of Ashley and Brad, you know what you’re talking about. To me, if that emergency comes up and you put it on credit, wouldn’t you be at the same position overall? I’d think you would’ve even saved some money on interest in the meantime.
Sorry for my ignorance in this matter, but I’d like to learn more about this. I guess the main point is that the person gets out of the habit of putting everything on credit, resulting in better long term success. So is it more about changing their way of thinking rather than worrying about a bit of extra interest?
I understand Jeremy and I hope my comment didn’t come off as disrespectful. My questions were asked out of curiosity and nothing else.
There are many factors that would make having an emergency fund for emergencies different than having a credit card for the same purpose.
A real emergency fund of $1,000 would be in an interest bearing account. If you’re paying off debt and an emergency arises, you use whatever portion of your EF to fund the emergency. No debt is accumulated and when you replace the money used for the emergency and start paying your debt off again, you’re not in a worse position than you were. If anything your debt situation has improved since paying at least your minimum payments for the time it takes to replenish the EF brings down your total debt.
On the other hand, if you use a credit card to pay for emergencies, unless you are able to immediately pay it off before any interest will accrue then you are not only paying for the emergency but also any interest that accumulates because of the financed emergency cost.
So the emergency fund placed in a savings account will earn interest while the credit card charges interest. And that’s just one aspect of it. Having the mindset of using a credit card to pay for any and all of life’s problems can become very risky to the person doing it.
“To me, if that emergency comes up and you put it on credit, wouldn’t you be at the same position overall? I’d think you would’ve even saved some money on interest in the meantime.”
As far as your comment about saving money on interest, I’m a little confused. It seems as though based on your previous statement that you’re saying that you’d save on interest if you used a credit card to pay for an emergency. Since you pay interest on credit and earn interest on a savings account I’m not sure how you’re arriving at that conclusion.
You’re exactly right about the need to move away from putting everything on credit. Most people do not pay off their credit cards every month which makes using credit the more expensive way to spend money from month to month.
“So is it more about changing their way of thinking rather than worrying about a bit of extra interest?”
Again I’m not sure I’m following you completely here. If someone were worried about interest then not using credit cards would be the way to go not the opposite which is what you seem to be implying here. If I misunderstood you or missed something let me know but yes it is mainly about changing your financial mindset and debunking the common myths associated with debt and credit that must be addressed.
You may want to read this excellent post about using credit cards as emergency funds. https://www.enemyofdebt.com/2012/01/credit-card-emergency-funds-an-alarming-trend-in-society/
Are you talking about if you had $1,000 in an emergency fund and took it out to pay for an emergency you would be losing interest instead of just paying for it with a card?
Not sure but if so then the interest you would be charged on credit would negate any interest you would trying not to lose in the savings account.
An emergency fund (in my opinion) is different from a life savings account. One is used specifically for emergencies (interest not important but a nice extra) and one is used for long-term savings (interest is wanted and expected).
Again not sure if that’s what you were thinking. I tend to try and not play that game. Some people justify not paying off debt by saying you should keep low interest debt and instead save what you would use to pay it off which would earn you more interest on your money than you would otherwise save by paying off the low interest debt. My brain gets tangled even trying to think like that about money. I think simple is better and all that is needed in order to come out ahead.
Thanks for the discussion Jeremy! 🙂 Good luck with your blog.
I guess I am looking at things more as someone who hasn’t had to deal with much debt. I have pretty good credit card habits. In my mind I would be comparing the interest rate on the credit card vs the interest you get on the emergency fund. People with debt problems need to actually address their bad financial habits though. Fixing the psychology is just as important as reducing the actual debt. Thanks for the explanation Brad.
I think you just summed it up in a nutshell Jeremy. You’re exactly right. People with debt need to be worrying less about interest rates and more about solid financial principles that will allow them to get out of debt and plan for a brighter future. 😀