Roughly 30% of Canadians don’t pay their credit card balance in full each month. To make matters worse, only 64% of Canadians have enough in an emergency fund to tide them over for three months. That means over a third of adults don’t have enough savings for emergency expenses.
Sound familiar? The lack of emergency savings became obvious during the coronavirus pandemic when more than 2 million Canadians were thrown out of work. With so many Canadians a paycheque away from making their monthly rent payment, should more have had an emergency fund?
And for those with debt which comes first: saving money in your emergency fund or paying down credit card debt? If you don’t have a rainy-day fund, is it fine to use credit cards or a line of credit during emergencies?
The truth is the answer is not as cut and dry as many financial experts make this sound. Even for me, a hold no debt guy, the answer lies somewhere in the middle.
Table of Contents
Redefining what an emergency fund is
OK, everyone knows why you need an emergency fund. In general, experts recommend you have a minimum of 3 to 6 months of living expenses to cover a catastrophic event like a job loss or sudden illness.
It takes a lot of savings to have this much money available in liquid assets. For someone with high-cost debt payments, saving up that kind of cash not only doesn’t make mathematical sense, it’s also next to impossible.
High interest debt like credit cards is a killer. At an annual interest rate of 19-21%, you’re paying around $200 in interest annually for every $1,000 of balance carried. With our average client carrying almost $15,000 in credit card debt their cost of carrying that debt load is $3,000 a year. If their monthly living costs for housing, groceries, transportation, child care, and other expenses are around $3,000 a month, you are asking someone to set aside an amount equivalent to the total debt they owe. The opportunity cost is a close to zero percent interest rate for a savings account against a credit card debt cost of $3,000 a year, even assuming they have the cash flow to save that much, which they don’t.
Catastrophic event vs emergency expense
I meet with people every day who face this dilemma. They are living paycheque to paycheque, barely able to make their minimum payments. This is when the smallest unplanned expense becomes a financial emergency. I’m talking about a car repair, new tires, gifts for Christmas, broken dishwasher, vet bill. Not significant life changes but financial hiccups we face every day.
The wrong solution is to turn to a payday loan or high-interest installment loan to cover an unplanned expense, but that’s what happens when you don’t have any money set aside, and you’ve already maxed out your credit cards.
Unfortunately, borrowing with a high-cost quick cash loan is what many of my clients do in this situation. That’s why almost 4 in 10 insolvent debtors have at least one payday loan. Taking on more bad debt to cover a small, but necessary, living cost is often the final trigger that causes bankruptcy.
Having even a small cushion in the bank can prevent this spiral into more debt.
Create a small buffer account while paying down debt
Even if you carry debt, I recommend saving $500 to $1,500 as fast as you can to cover the small life costs that you know will come; you just don’t know when. If you drive an old car, you know that at some point something is going to break.
A small contingency fund is a financial safety net that you use for sudden small expenses. With this, you can better manage your bills even in the face of a financial crisis. It also helps you avoid taking on more debt. It’s not the same as an emergency fund, which is more about income replacement or a major financial disaster like your house burned down.
I’ve talked about the 80-20 rule of money management before where 20% of the effort produces 80% of the results. A planned $1,000 account for unplanned expenses is like that. You’re 20% of the way towards your full emergency fund, but that small amount can stop you from spiraling further into bad debt.
Yes, I know putting $1,000 in a zero-interest savings account could save you $200 if you put that money against your credit card. But in this case, what we are trying to avoid is toxic debt like a 390% payday loan or a 59% installment loan.
Even if you don’t turn to a payday loan and have room on your credit card, driving up your balances is demotivating.
Having an expense slush fund also reduces the risk that you’ll miss a payment on your credit card debt. There is nothing more stressful than deciding between paying your credit card or paying for a car repair. Having a small amount set aside eliminates the risk that you’ll not only have to deal with the extra bill but late payment charges on your credit card statement as well.
As you’re saving up, you should continue to make more than the minimum amount due on your credit card bills when you can. This helps to reduce your compounding interest payments. If you keep paying just the minimum, you’ll remain in credit card debt for a long time.
How can you fund this slush account?
- Setting aside just $20 a week will build a cushion of $1,000 within a year.
- Set up automated savings, so it doesn’t even hit your chequing account.
- If you are paid bi-weekly and hit a 3 paycheque month, take one pay and set that aside.
- If you get a tax refund, set some aside (and use the rest to pay down debt).
- Sell something. We all have a lot of stuff, much of which we don’t use. Sell off what you no longer need.
Once you have enough money in your slush fund, use the avalanche method to deal with the rest of your debt. Focus on paying off all high interest rate debt before setting aside significant savings in a rainy day fund. Once you have debts like credit cards, payday loans, and installment loans paid off, you can start building a larger emergency savings fund.
Is it ever a good idea to use credit cards as an emergency fund?
Unless it’s a life-altering kind of situation, it’s best not to rely on credit card debt or a line of credit in place of emergency savings. Convenient as they are, there are quite a few dangers of using credit cards for emergency funds.
Obviously, there’s the high cost of compounding interest. Rolling over your balances from one month to the next leads to more interest payments.
And, if you treat your cards as a source of available funds, like an ATM if you will, you’re likely to get into the habit of just charging it, and rebuilding your debt balances higher again.
You can use a credit card to pay for emergencies so long as you can pay off the entire amount before interest applies. That means paying it down before the next billing cycle starts.
Yes, I know that many bankers will tell you if you have assets like a home, you can use a secured line of credit or HELOC as an emergency fund. I still think it’s a bad idea. An emergency savings fund is for when you’ve lost your income. That makes keeping up with mortgage payments hard enough. Now you are going to be using debt to pay for all your other living costs. Once you return to work, you are facing much more debt.
Relying on credit card debt or a line of credit just means you can continue the model of spending today, rather than saving for a disaster tomorrow.
As I said, the answer is not as simple as pay off debt or save for an emergency. You need a balance between savings and debt repayment that protects your future finances.
If faced with the dilemma of paying off debt vs an emergency fund, my recommended steps would be to:
- Create a small slush fund for unexpected living expenses, say $500 to $1,500 while paying at least the minimum on all your debts.
- Put all excess cash towards paying down high-interest debt next.
- Once your credit card balances are paid off, start building an emergency fund for catastrophic events that can lead to income loss.
- Once you have 3-6 months in liquid assets (like in a TFSA), pay off other consumer debt like your car loan.
- After that, save more, pay down your mortgage, and invest.
Again, every situation is unique. How long it will take and how much you can save will depend on your personal circumstances. But if you want to avoid the roller-coaster of being thrown deeper into debt, you need a plan that focuses both on debt reduction and disaster recovery.