I very much hope that you have an emergency savings account. I recognize that not everyone does, but if you do…
There is an interesting area of behavioral economics research that suggests that when some people face a financial emergency, they prefer to borrow money even when they have ready funds available to meet the crisis. It’s ironic, isn’t it? You save for a rainy day and then when the cloud bursts, you don’t want to reach for the umbrella.
Researchers theorize that this seemingly irrational behavior stems from our sense of responsibility (or perhaps lack thereof). More specifically, if you borrow money you have entered into a hard commitment to a lender to pay it back. But if you take the money from your savings account, no one will make you return it. Mental accounting also plays a role. It is even harder to “dis-save” if you have earmarked the savings for the benefit of your child.
Think about it. You patiently built up that pool of savings over months, maybe longer. And, well, it just looks good sitting there. You see the balance on your screen and it’s like a warm blanket wrapped around you, protecting you from the cold. How can you possibly part with it? Rationally, you know that using your credit card to get by at this time and paying 19% interest for the privilege does not make economic sense, and yet…
Research provides a possible solution. In a lab experiment, researchers found that when subjects were given the option of taking money from savings and entering into a “pay-back” agreement, they were more willing to use their savings rather than borrow money.
So, consider mimicking the “commitment feature” of borrowing money by setting up an automatic repayment schedule to your emergency savings. For example:
If you use your credit card to make a $500 purchase, your minimum payment the following month is likely to be about $25.
Instead, withdraw $500 from your savings and at the same time, set up a monthly auto-transfer from your checking account to savings of $25 for 20 months. (You can increase that amount later as your situation improves.)
The effect on your monthly cash flow is exactly the same, but you have saved more than $100 in interest charges. And if you were thinking of taking a cash advance on your credit card, the difference is even more stark; that cash advance will cost you more than $150 in fees and interest.
Depending on how much you have saved, you may arrive at a point where your balance is so meager that you simply cannot bear to part with the last few dollars in the account, or perhaps it is exhausted completely. That is when borrowing becomes the next option. But not before.
This is an incredibly anxious time and we all know that humans do not necessarily make the best decisions in times of stress. It is even more important right now that when we are considering a money decision, that we take a deep breath and think before we act. When faced with a range of possibilities, not all of them to your liking, it is vital to think clearly about which option will set you up best for future success, so that eventually you arrive “on the other side” as financially healthy as possible.
Damian is the lead Financial Concierge on Your Money Line, the financial help line serving all Pete the Planner® Financial Wellness clients. Damian is a CERTIFIED FINANCIAL PLANNER™ professional and loves answering your money questions. Despite sharing a last name and sense of humor, Damian and Pete are not related.