A new Bankrate survey that examines how much people have in credit card debt compared to emergency savings raises in interesting question: How much should you keep in an emergency fund if you also owe money on your credit cards? My answer is: very little, if anything.The Bankrate survey of 1,004 consumers revealed that three in every 10 Americans have more credit card debt than emergency savings.
Of course, having any credit card debt is reason to worry. And too many people are living paycheck to paycheck, a problem underscored by the recent federal shutdown.
But what if the survey found the opposite, that people have more in savings than credit card debt? That's actually worse because it would mean that they are keeping money in savings accounts earning, say, just 2.5 percent while paying double-digit interest on their credit card debt. That makes no sense.
Think of it this way: Would you borrow money at, say, 22 percent interest so you can put it in the bank at 2.5 percent? Of course not. But that's essentially what you're doing if you're stashing money into an emergency fund while also paying credit card debt. Having an emergency nest egg might make you feel better, but the cost is way too high.
Consider this example. Suppose, despite your credit card debt, you try to follow the advice of financial gurus and create an emergency fund equal to eight months of living expenses. If the monthly expenses for your family of four total $5,000, your emergency fund would need to have $40,000. If you tried accumulate that much in 12 months, you'd have to sock away more than $3,300 a month. To achieve that in three years, you'd be putting away $1,100 a month. But if you had that kind of money to put into savings consistently, month after month, you probably wouldn't have credit card debt to start with, or you would have seriously mismanaged your finances.
Even if you got a sudden surge in your monthly income or inherited a big chunk of cash, does it really make sense having tens of thousands of dollars in an emergency fund while you're getting killed paying credit card interest? The fact is, if you have credit card debt, that is an emergency that you need to address ASAP. Not only are you likely paying high interest, but when you carry a balance on a credit card, you lose the interest-free grace period of 30 days or so, which means having to pay interest on every purchase you make from day one!
On the other hand, if you use your spare cash to pay off your debt and an unexpected high-cost emergency arises, such as a major car or home repair, you always can, as a last resort, use your card to pay for it, assuming you haven't maxed out your credit. Yes, that's not an ideal solution. But if you're keeping a higher credit card balance so that you can maintain an emergency fund, you're essentially borrowing as a hedge against an emergency that may not even happen.
Of course, the main point of the Bankrate study is to demonstrate that we're a society in crisis financially. A 2017 study (pdf) commissioned by the Federal Reserve found that four in 10 adults couldn't handle a $400 emergency expense without having to borrow money or sell something. That's scary. But the main take away from all this is not that people have more debt than savings; it's that they're charging more than they can pay off in a single month, period.
The Bankrate survey suggests that things are only getting worse, which is hard to understand given the improving economy and low unemployment rate. It could be that consumers, more confident in how they're doing financially, are willing to take on more high-interest debt and the risk it involves, which is exactly the wrong approach! If you're in good shape financially, now is the time to get your financial house in order and to keep it that way.
What to do
Throw every extra penny you have at your high-interest debt. Make a budget that can serve as road map for getting yourself debt-free (more on that later). One exception is if you've maxed out your credit and wouldn't have any way of covering an emergency. Then it might make sense to maintain some money in savings. But use your judgment. Those credit cards are costing you far more than you could ever hope to earn in a savings account.
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