For this week’s Reality Cheque, we’re looking at the money myth about using a line of credit for emergencies.

By Jessica Martel  

You know you need an emergency fund. But when money’s tight, just keeping up with everyday bills can feel like a stretch. Some of your friends might recommend using a line of credit as an emergency fund, but is this a good idea? 

Short answer: Yes (and no). Advice-only financial planner and podcaster Sandi Martin says, “If your line of credit is your only way to stay housed and fed, use it. Otherwise, no.” 

So, what should you do to prepare for an unexpected expense when money is tight? Let’s dig into the details of what makes a good emergency fund and what you want to avoid. 

What’s an emergency fund?

Life is unpredictable. An emergency fund is money set aside to cover unexpected expenses, like a car repair, job loss, or a new furnace. Ever notice how these things often happen in the middle of winter?

Martin believes everyone needs an emergency fund. “Emergencies don’t care if you have a great income, good insurance or a big investment account,” she says, adding that sudden costs “can happen to anyone, at any time.”  

As a general rule, it’s recommended to save three to six months (or more) of expenses. The goal is to cover your minimum costs, things like rent, utilities, gas and groceries—not discretionary expenses like subscriptions and new clothes. 

How an emergency line of credit can become costly 

“Many people don’t realize that a line of credit is a demand loan with a variable interest rate,” Martin explains. A demand loan means your lender has the right to reduce your credit limit or require repayment. A variable interest rate means your rate can rise or fall unexpectedly. Check the terms of your line of credit to understand how you might be impacted by both.

To see how the cost of using your line of credit as an emergency fund can add up, let’s look at an example. Say you lose your job and are out of work for three months. You have no cash emergency fund, so you turn to your line of credit. 

Your essential expenses total $3,000 per month, and your line of credit has an annual interest rate of 10%. You start paying interest the day you borrow the money. 

Over three months, you’ll need to borrow $9,000 (3 x $3,000). Since you borrow the money gradually, each month’s balance will accrue interest over a different amount of time. (To keep the calculation simple, though, we did not compound the interest.)

To calculate interest, you can use the following formula. 

Interest = (Balance x Annual Interest Rate x Days outstanding) / 365

• Month 1: ($3,000 x 0.10 x 90) / 365 = ~$74
• Month 2: ($3,000 x 0.10 x 60) / 365 = ~$49
• Month 3: ($3,000 x 0.10 x 30) / 365 = ~$25

Total interest = $74 + $49 + $25= ~$148

While $148 in interest might not seem like a ton of money today, remember that is what is owed on top of the $9,000 borrowed. Most lenders require you to pay at least the interest on the line of credit each month, so you’ll need to have that cash available to cover this cost. Also, remember, the longer it takes to pay back your loan, the more you’ll spend on interest. There’s also a chance your interest rate could rise, further increasing that cost. 

Where to build an emergency fund

If a line of credit isn’t ideal for an emergency fund, what is a better alternative? Martin advises building a cash fund that you can access anytime, from anywhere, with no penalties. 

Here are some different ways to set up an emergency fund.  

• Savings account: Open a savings account that’s separate from your other bank accounts, so you’re not tempted to spend it. 
• High-interest savings account (HISA): A high-interest savings account is like a regular savings account, but you earn a bit more interest. 
• Tax-free savings account (TFSA): If you have unused contribution room, Martin suggests that a TFSA can be a good place for emergency savings. If you can afford to use all of your contribution room, she recommends using it for long-term investments and keeping your emergency fund in a non-registered account. 

Why do Canadians turn to credit for emergency savings?

So, if using a line of credit as an emergency fund is generally frowned upon, where did this myth come from? 

There are a few possible sources: Necessity, access and profit.

• Necessity: If you don’t have enough money to cover your bills and save an emergency fund, Martin says, using a line of credit can be the only option for some Canadians. 
• Access: Lines of credit are easy to access in an emergency—if you already have one available to you—and the interest is much lower than a credit card (think 8% to 11% versus 19% to 30%). But it still costs you in interest to access this money, as opposed to using savings (which typically earns interest, which can be compounded for more growth). 
• Profit: A line of credit costs Canadians in interest and fees, so using it for emergencies benefits the bank’s bottom line. Having cash sitting in your account that earns you interest isn’t as profitable for the bank, when you compare savings accounts versus lines of credit. 

Choose a cash emergency fund, if you can 

A good emergency fund, Martin says, is one you can access within a short time and without withdrawal penalties. “A great emergency fund is money that you can access at any time, even in the middle of the night in Nowheresville. Earning interest is fine, but access trumps interest.”

If you have the time and means to save for a cash emergency fund, instead of planning to use credit, your unexpected expenses will end up costing less money. Using a line of credit can put you into a financial hole that you have to crawl out of once the emergency passes. Bottom line—use the line of credit to keep the lights on if necessary, but otherwise, aim to create cash savings. It will take time, but the money you earn from interest and save from paying interest is worth it.

Jessica Martel, MSc is a freelance writer, researcher, and certified financial education instructor (CFEI). She is based in Calgary, Alberta.