Emergency fund money critical in a crisis
Having cash on hand can help when credit tightens
By - - | Published: October 20, 2008
The Credit Guy
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
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?
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