Emergency fund money critical in a crisisHaving cash on hand can help when credit tightensBy Todd Ossenfort
Dear Credit Guy,
With
the economic crisis right now, does it make more sense to pay off my cards or
hold on to that extra cash? Also, if I pay off my cards, will the credit freeze
not allow me to use them in case of an emergency (note I say emergency)? Thank
you!
-- Debra
Dear Debra,
It
is great that you are being proactive and are planning how best to manage your
personal finances during this current economic cycle. Planning is an essential
element in money management, particularly during uncertain financial times.
During
a tight credit cycle, when lenders are much stingier with the money they have to
lend, it is important to have some cash on hand. The old saying really rings
true -- "Cash is king!"
It is unlikely that the credit squeeze will get so tight that we have no credit
available, but it never hurts to be prepared. You don't want to be in a
position to have to borrow when the price of credit is high, maybe even too high
to afford.
How
much cash you need on hand is a balancing act. In your case, you will want to
continue to pay off your credit card debt to ensure that you do not take a hit
on your credit score if your lender lowers your credit limit. Lowering credit
limits is one action card issuers may take to free up unused credit. If the
limit is lowered and your balance is more than 50 percent of the new credit
limit, your credit score will be negatively affected.
On
the opposite side of the coin, you will want to keep enough cash on hand for
any emergency expenses rather that needing to rely on credit. Three to six
months of living expenses is a general rule of thumb to follow for emergency
savings. Just to be clear to you and my readers, emergency savings is a must
during any economic cycle -- not just when we are experiencing a downturn.
So,
in your particular case, Debra, I would recommend that you establish your
emergency savings account first and then determine how much extra cash you have
available. Use this extra cash to pay down your credit cards.
As
an example, let's say you have credit card balances of $4,000 with an $8,000
credit limit on one card and a balance of $2,000 with a credit limit of $4,000
on the other. In this example, you would be at 50 percent of your credit limits
on each account. If the creditor decided to lower your limits to $6,000 and
$3,000, you would then be over 50 percent of your limits.
To
help avoid taking a hit on your credit report if your limits are lowered, you should
make sure you stay well below the 50 percent of the balance mark. I would also
recommend that you use any extra cash each month to continue to pay down your
credit balances and wipe those out as soon as possible.
Once
you pay your card balances in full, I would recommend continuing to charge
small amounts each month and pay off the balance in full to avoid the creditor
closing your accounts for inactivity. Closing inactive accounts is another
action card issuers use to access unused credit during a tight cycle. Taking
this precaution would assure that your accounts will stay open and are
available to you in the future.
Take
care of your credit!
See related: Will cash become king again?
Todd Ossenfort is the chief operating officer for Pioneer Credit Counseling in Rapid City, S.D. Pioneer Credit Counseling has been a member of the Association of Independent Consumer Credit Counseling Agencies since 1997.
The Credit Guy answers a question about a debt or credit issue from a CreditCards.com reader each week.
Send your question to The Credit Guy.
Published: October 20, 2008
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