As a financial planner, I am frequently asked about credit cards, and what someone should do with credit cards that they no longer use. After running across this topic on a credit card forum, I decided it was time for a post.
People will debate about the reasons to keep credit cards open, including using them for emergency spending, instead of or in cases of no emergency funds as part of a holistic cash reserve strategy. Credits cards are not emergency funds. 100% correct. However credit cards MAY be the solution for the large part of America that does not have enough in savings. Let’s examine how credit cards and other credit products may fit as part of a holistic cash reserve strategy.
For most people, we recommend having 6 months of committed, non-discretionary expenses as part of a cash reserve strategy. Note that it is 6 months of expenses, not 6 months of salary. Why? Many people struggle to even stay afloat on a monthly basis, living above their means, therefore for emergencies, you should plan for the expenses, not merely how much you are bringing home as income.
So, if someone loses their job, assuming an average breadwinner, it would take them an average of 3 to 6 months to find another suitable job. With a cash reserve, you would have those expenses in savings. If you have an emergency, figure you would be ok, as long as you are not going out to eat every day or supporting the 2 cups of Starbucks a day habit.
Having 6 months of expenses in a cash reserve strategy does not mean you keep 100% of that in a savings account earning you nothing. With a proper cash reserve strategy, you would want to have the funds available within 2 to 3 days. A typical 6 month cash reserver strategy would look like this.
Tier 1 : 1 month of expenses available in a checking or savings account that is readily available. These are funds that you use on a daily basis. This is also where your paycheck comes in. Money in, bills go out. The primary purpose here is readily available funds.
Tier 2: 2 to 3 months of expenses in a high yield savings or money market account. These funds may be used from time to time to make up for any short term emergencies or opportunities that may come up. This could be either a linked money market account, or even an online high yield savings account. Your goal here is a combination of liquidity and earning enough interest to make it worthwhile.
Tier 3: 3 months or more of expenses in a short term, or low duration tax free fixed income fund. A 3 month Tier 3 would mean 6 month total cash reserve, while more conservative people would have more. The highest we would recommend is a 12 month total cash reserve, for conservative clients, who are in retirement.
For those that do not yet have a complete cash reserve, we suggest temporarily using a HELOC, a home equity line of credit, to backstop the cash reserve strategy. If you do not have enough in home equity or no home, we can live with having clients use low interest credit cards until they can have enough in emergency funds.
Yes, having credit card debt is typically bad, however let’s be honest, if you just lost your job, and you have no savings, and you need to put food on the table, or your roof is leaking, or hot water heater just blew up, you do what you have to do. If credit cards is it, then do it, then responsibly get yourself out of the debt.
Having said that, why would you want to close a credit card, that costs you nothing to keep open, and is not preventing you from getting new credit? I feel it is irresponsible to close them. No one is going to lend you money when you most need it. *(Except a hard money lender who will charge exuberant rates.)
For the same reason you do not start building a cash reserve DURING an emergency, you do not get rid of available credit just because you do not need it. That is the point, you don’t want to have to use it… but you need to have it there during those bad times. Ford survived because they did not get rid of their lines of credit before the economy fell into a recession. This is one of key reasons that Ford did not have to file for bankruptcy protection while General Motors and Chrysler did.
Beyond the basic cash reserve strategy, every client we work with, we recommend that they have a securities backed line of credit against their investment portfolio that they have, if it is available to them. A line of credit costs nothing to setup and maintain, and offers rates as low as 1% when you need to use it. This can be yet another extended cash reserve option.
Credit is obviously a tool, and you must be honest with yourself. One of the only reason we would recommend someone to close any unused credit cards is they have a history of irresponsibility with credit in the past. These people would typically use credit to finance purchases, to purchase what they cannot afford, rather than purchasing what they need.
One of the biggest problems that I see in the United States, and one of the main reasons for the lack of personal savings is that people ask themselves… “Can I afford the monthly payment?” and not “Can I afford to pay it out of savings in full?”
Unfortunately our economy is built upon frivolous spending, where many people have paid more for their families iPhones, than they have in an emergency account.
The big exception to being in debt is the purchase of a home, since you would hope the home values would go up over time or at least remain constant. Then again, what would we say of the American dream if everyone had to pay for a house in cash?
As long as the American economy is based on the “I Want” instead of the “I Need”, and the desire to be perceived as being cool or popular is stronger than the knowledge of being fiscally prudent, being in debt will be a real concern for most Americans. My hope is that the people we work with and care about are financially prepared, before the next big “gotta have” item is released.
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