Saturday, January 11, 2014

Credit Card Use Erodes Your Emergency Fund

It has been almost 2 weeks since we cut up our credit cards, and I have some thoughts to share.

The Goals
I have two major goals for discontinuing my use of credit cards:
  1. Spend less - As mentioned in my blog post last week (My Only Use For Credit Cards in 2014), I hope to reduce my expenses by more than $1,000 in 2014, the amount of the rewards I earned for using credit cards in 2013.
  2. Reduce the amount needed in emergency funds - I will discuss this one below.
Working Capital
You may think that the concept of working capital only has to do with business cash flow, yet it has everything to do with credit cards and your personal finances. Let me explain.

I will use my recently cut-up American Express card as the example. The billing period ended about the 5th of each month, followed by a 25-day grace period until payment was due for all purchases made during the billing cycle. As long as I made my payment by the 1st of the following month, or the end of the grace period, I didn't have to pay any interest or any penalties...I got all that extra time for free, and I even got paid (in the forms of credit card points and rewards) for doing it.

If I bought my wife a Christmas present on December 7th with my American Express card, I would not have to pay for it until February 1st of the next year. That is about 55 days between the day I received the product and when I had to pay for it. Why do credit card companies give so much to make nothing on a guy like me who uses every day of the "float" but always pays off his balance every month? I think they are betting that, at some point, I will have an emergency for which I am not prepared, and they know I will likely not pay off my balance, incurring interest and fees.

So how does working capital and credit cards impact personal finances?

Corporate and Personal Finance
In corporate finance, the longer you can postpone paying for things the better. Anything that can be done to stretch out the days between when you receive goods and when you pay for them squeezes the need for cash to be consumed in the working capital cycle. Or, in other words, it makes cash flow look better and working capital turn over faster, both things that can increase the perceived value of a business. However, and this cannot be understated, it is a liability that grows with every day that passes.

Liabilities are risks...promising to pay for something in the future. Liabilities are debt!

In personal finance, a way to find some extra cash is to postpone paying for things. The 55 days afforded by my former credit card is an example. But is this a wise way to handle your money? I don't think so. You are exposing yourself to additional debt and you will need more emergency funds to properly mitigate the risk associated with this debt.

Emergency Fund
Experts recommend having as little as 3 months and as much as a year's worth of living expenses set aside in a liquid account (like a savings or money market account) for emergencies. I am comfortable with 6 months for my situation, all things considered. However, if for some reason I could not earn a living for some period of time, my six months of emergency funds wouldn't last me that long. Why? Because I would have purchases as many as 55 days old for which I still have to pay, and those are in line before the current purchases.

The conclusion: Credit card billing cycles and grace periods erode your emergency funds.

Getting Current
So, here we are in January. I have paid cash for everything I have purchased so far this month. I also have the debt from my December purchases that I am paying off this month, too. This is painful. I feel like I am paying for two months instead of just one, mainly because we were trying to put everything we purchased on our credit cards so we could maximize the rewards we could earn. I gave myself just one month to get current, and, although it is painful, it will be worth it. My net worth will improve. My emergency funds, if needed, will be able to serve their purpose for the duration designed. And I am one step closer to accomplishing my goals for fiscal fitness in 2014.