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Friday, January 29, 2010

A big no-no for building an emergency fund

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CNNMoney.com

A big no-no for building an emergency fund

Growing a savings cushion is tough when your budget is tight. One method that is not a solution - credit cards.

By Walter Updegrave, senior editor

(Money Magazine) -- Question: . My wife and I know we should have an emergency savings fund, but with one income we have nothing left to save after paying expenses.

But I've been thinking of a way to deal with this problem. We charge about $2,000 in monthly expenses to our credit cards, which we then pay in full each month.

My idea is this: Instead of paying off the cards every month, I'll make only the minimum required payment and save the rest. Once I've accumulated a decent emergency fund, I would then begin paying down the cards. Do you think this is a good strategy? -- N.G., California

Answer: In a word, no.

I applaud the fact that you want to set aside some savings for emergencies and such. The fact that the Congressional Budget Office estimated earlier this week that the unemployment rate will remain over 10% for the first half of this year and won't decline to the economy's "natural" rate of 5% unemployment before 2016 is just another reminder that we should all try to have three to six months' worth of living expenses tucked away in a safe place to get us through tough times.

But the way you want to go about doing this is all wrong. To put it bluntly, you can't borrow your way to security and prosperity. If nothing else, the behavior of American consumers and our government in recent decades proves that. What's more, doing what you suggest could jeopardize your overall financial health.

Let's step back for a minute and take a closer look at what you're now doing and what you propose.

At the moment, you're essentially using your credit cards as a payment mechanism that allows you to pay bills without writing checks or shelling out cash. People in the credit-card biz call someone like you a "deadbeat." No, in this context that doesn't mean you don't pay your bills. Quite the opposite. It's a derisive term the industry applies to people who pay their balance in full each month. Card issuers don't like people who do that because it's more difficult for them to make money off of you.

So I have no problem with the way you're currently using your credit cards. Your system can work fine, provided you pay your balance faithfully so that you don't incur interest charges, and as long as you're not paying a big annual fee to the card company. Depending on the type of cards you have, you may even be able to get some extra benefits, like cash back on purchases, reward points or other perks (although it's unclear how such reward programs will fare once the second stage of the recent credit-card reforms begins kicking in next month).

If you go through with your plan, however, you'll become what card issuers call a "revolver" -- that is, a person who carries over a balance month to month. Card companies like revolvers because they pay interest and sometimes incur late charges and other fees.

As a revolver, you will wind up with cash at the end of each month that you didn't have before, specifically the difference between the $2,000 a month you charge and the minimum payment you make. And assuming you actually save this cash -- as opposed to spending it on some other need that pops up -- you could indeed build a decent size emergency fund fairly quickly.

The exact amount would depend, among other things, on the interest rate your card charges, how it calculates the minimum payment on your balance and the rate of return on your savings. But by my back-of-the-envelope estimate, you might have just under $11,000 in savings within six months. Clearly, you would have more if you kept this up, although how much you could accumulate would depend on your cards' credit limit.

Now, $11,000 in savings in six months might sound pretty attractive, especially to someone who's had trouble putting any money away. But remember, we're looking only at one side of the ledger here.

On the other side, after charging $2,000 a month and making the minimum payments, you would probably have a credit card balance somewhere north of $11,000. (Again, the exact amount will depend on the specifics of your card, not to mention how you spread out your charges over the month.) And while your savings balance would be likely generating interest of 1% to 2% a year, depending on the type of card you own, you would simultaneously be paying interest of somewhere between 10% and 18% a year on your credit-card balance.

In effect, your strategy amounts to paying 10% to 18% a year to acquire money on which you will earn only 1% to 2% a year. That's not a winning proposition.

More importantly, though, your strategy doesn't really even solve what you say is your basic problem -- i.e., the fact that you have no money left over to save after paying your expenses. Here's why.

Let's say you follow your strategy for six months and end up with a credit card balance of $11,000. At that point, you'll still be incurring the $2,000 in monthly expenses you're racking up now. Assumedly, those expenses aren't going away. But you'll also have an additional expense -- namely, paying off your credit card debt. Even if you make only the minimum payment, you're still talking about a decent sum. For example, if your card requires you to pay 4% of the outstanding balance, your minimum payment would start at $440 a month. (To see the minimum payment at different interest rates as well as how long it would take to pay off the balance at different interest rates and monthly payments, click here.)

So the question is, if you can't save today because you have no money left after paying your expenses, how are you going to pay those expenses, plus come up with an extra $440 a month to pay down the credit card balance you racked up to accumulate your emergency fund?

In short, while your strategy may seem to offer a shortcut to savings, what it really offers is the illusion of saving.

So what should you do instead?

Well, the reality is that there is only one way to save -- and that's to spend less than you make. There are a number of ways to do that. You can go the "cut the latte" route and avoid relatively small daily expenditures that add up. You can create a budget and then go over it line by line, looking for specific areas to squeeze. You can try two techniques that I've advocated in the past, focusing on big-ticket items or employing strategies that can effectively fool you into being a better saver. Whatever works for you. But one way or another, you're going to have to find a way to pare your spending.

To sum up, if you want a shot at true financial security -- which means not just building an emergency fund but continuing to save throughout your working years for retirement -- you'll have to find some way of putting money away on a regular basis.

I'm not saying this will be easy. Having grown up in a family that struggled financially I know it won't be. But I also know that borrowing to save is an oxymoronic concept that's more likely to create problems than solve them.

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