According to a recent report by Bankrate.com, nearly one-fourth of Americans have more credit card debt than emergency savings, and another 13% don't have any emergency savings at all. Although those numbers have improved over the past year, many people are still woefully unprepared.
While credit cards can be helpful when you need them, they are no substitute for an actual emergency fund. Here's how you should prepare for a financial emergency, as well as how to get started.
Don't count on cards
Many people plan to simply use their credit cards in the event of a financial emergency. While this is certainly better than having no emergency options at all, a credit card is no substitute for a cash emergency fund.
For starters, credit cards have to be paid back, and your card issuer will expect some money relatively soon. Let's say you become unemployed. Sure, you can charge your day-to-day expenses, but if you have no money in savings, what will you do when the bill comes due?
Further, some things can't be paid for with a credit card, especially big expenses like your mortgage or car payments. If your cash flow is interrupted for any significant length of time, credit cards likely won't be of much help for these expenses.
Also don't forget that whatever you charge on your credit cards will need to be paid back with interest. If you only make the minimum payments, it can take years to pay everything off, and the interest can cost you several times the original amounts you charged. For example, if you're unemployed for a few months and end up charging $5,000 in expenses and bills, you could end up paying more than double that amount over time. Why not just save some money so that $5,000 in expenses actually costs you $5,000?
Finally, a major factor in your credit score is how high your credit card balances are relative to your limits. By running up your credit cards in a financial emergency, you could see your score drop significantly, which can make it tougher to borrow more money if you need it.
How much do you need?
There's no magic number to aim for, as everyone's expenses are different. However, a good rule of thumb is to build up six months' worth of expenses in a readily accessible place, such as a savings account.
Many people don't realize just how much money they need for six months of expenses. When figuring out the target amount for your emergency fund, make sure you consider:
- House payments
- Car payments
- Gas for your car
- Other monthly recurring bills (alarm system, HOA dues, etc.)
- Extra for expenses that might come up (like car troubles)
This can be quite a bit of money, so it may take some time to get there. However, something is better than nothing.
Every little bit helps
When you figure out how much you would need to comfortably afford six months of living expenses, the total can easily stretch well into the five-figure range. If you don't have any emergency savings yet, this may seem like an impossible goal.
However, whatever you can manage to save now is better than nothing. Try saving a set amount of money out of each paycheck -- say, $50 -- and increasing that amount as you feel comfortable. Or try eliminating some extra expenses and stashing that money aside.
Any amount of emergency savings can make your life easier in the event that you need it.
Matthew Frankel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.