Emergency fund vs line of credit: Which is better?

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Life has a way of throwing us curveballs. It's not uncommon for cars to break down  and require a $1,500 repair, or maybe you receive an unexpected medical bill of $800… Are you financially prepared to handle these situations without derailing your budget?

According to a recent survey, nearly half of Americans admit they don't currently have an emergency fund that could cover even $1,000. This leads many to rely on credit cards or personal loans to cover unexpected expenses, which could put more Americans into debt. 

We could all benefit from a responsible financial fallback option. Two of the most popular routes are emergency funds and lines of credit. But which one is right for you? Let’s break down the pros and cons of each so you can make an informed decision and feel more in control of your financial future.

What is an Emergency Fund?

An emergency fund, often referred to as a contingency fund, can serve as a financial cushion for unforeseen circumstances or sudden expenses like car repairs, medical bills, home maintenance, or loss of income. It can act as a dedicated cash reserve, safeguarding your finances and offering peace of mind in times of crisis.

Ideally, emergency funds should cover 3-6 months of living expenses, so if you have $3,000 in your emergency fund and your monthly living expenses are $1,500, then you have a two month safety net. If you make between $50,000 and $100,000 per year, you could even be part of the 33% of Americans with six months worth of living expenses stashed away.

When establishing an emergency fund, people can build money fastest by finding and storing their cash in a high APY saving account. For example, the Varo Savings Account offers customers up to 5.00% APY (Annual Percentage Yield) on the money in their account¹.

What is a Line of Credit?

Similar to an emergency fund, a line of credit is another form of financial support that can be used when you’re hit with unexpected circumstances like medical bills, home repairs, or car maintenance. The difference is that instead of having money saved in advance, a line of credit can allow you to tap into a predetermined limit of funds when you need it, in exchange for paying interest on the amount borrowed (or in the case of Varo Line of Credit², for a single flat fee).

There are a few different types of lines of credit:

• Personal lines of credit: A flexible borrowing option that can allow individuals to access funds up to a predetermined limit for various personal financial needs.

• Home Equity Lines Of Credit (HELOC): A revolving line of credit secured by the equity in a homeowner's property, providing flexibility to borrow against the home's value for expenses like home improvements or major purchases.

• Business lines of credit: A revolving credit facility tailored for businesses, enabling access to funds up to a specified limit to manage cash flow, cover operational expenses, or seize growth opportunities.

Note: Varo is always looking for new ways to provide our customers with helpful financial offerings. However, we do not currently offer HELOCs or business lines of credit. If you’re looking for an unsecured personal line of credit, check out Varo Line of Credit. For a secured credit product instead, look into the Varo Believe Credit-Builder Card³.

How Lines of Credit Work

Lines of credit typically happen like this:

• You apply for a line of credit with a lender who will set your credit limit based on factors like your credit score, income, and debt-to-income ratio. Each lender has different criteria so we recommend reviewing approval factors at your financial institution.

• Once approved, you can borrow money up to your credit limit whenever needed. Remember, you only pay interest on the amount you borrow, not the full credit amount available.

• Make monthly payments to pay back what you borrowed, plus interest. 

• As you pay down your balance, the money you can borrow can reset, providing you the freedom to borrow again when necessary.

Interest rates on lines of credit tend to be typically higher than traditional loans, but lower than credit cards. There may also be fees associated with opening and maintaining a line of credit, such as annual fees or prepayment penalties. Be aware of all associated costs for a line of credit during the application process.

Lines of credit can also be used in combination with emergency funds. Let's say your car needs a $2,000 repair, but you only have $1,000 in your emergency fund. You could use the $1,000 from your emergency fund and take out $1,000 through your line of credit to cover the remaining amount. Alternatively, if your bank offers a large enough line of credit, the entire $2,000 could be borrowed to prevent draining your emergency fund completely.

The key is to use your line of credit strategically and not rely on it for everyday expenses. It should be treated as a backup plan, not a crutch. Lines of credit are a form of debt and should be used responsibly. Before borrowing, have a plan to pay back what will be owed.

Read more: How to get a line of credit with bad credit

Pros and Cons of Emergency Funds

Emergency funds can be a fantastic tool for financial preparedness, but they have drawbacks. Let's take a look at the pros and cons.

Advantages of Emergency Funds

• Flexibility: An emergency fund is liquid and easily accessible. It can allow you to address various unforeseen situations like car repairs, medical emergencies, or job loss without jeopardizing your long-term financial goals.

• Avoiding Debt and Interest: Emergency funds can help prevent getting into additional debt when faced with sudden financial needs, without worrying about interest or paying additional fees.

• Improved Financial Habits: Emergency funds often encourage better financial habits like saving and budgeting.

• Seizing of Opportunities: In addition to being a backup plan, emergency funds could also be used when unexpected financial opportunities present themselves.

Disadvantages of Emergency Funds

• Maintenance: Emergency funds sometimes require regular monitoring and contribution. They can take time to build up, especially if you’re starting from scratch.

• Limited Coverage: Emergency funds may fall short in covering significant expenses such as major home repairs, which could deplete the fund and necessitate additional sources of funding or borrowing.

• Opportunity Cost: Maintaining an emergency fund requires money that isn’t being put into other ventures with greater earning potential. 

• Inflation Erosion: The value of money in an emergency fund may decrease over time due to inflation, potentially reducing its effectiveness in covering future costs long-term.

• Temptation: Having easy access to cash might create a temptation to dip into the fund for non-emergencies, compromising its intended purpose.

Pros and Cons to Lines of Credit

Lines of credit can be a useful financial resource, but like emergency funds, there are some pros and cons to be aware of.

Advantages of Lines of Credit

• Flexibility: Lines of credit can offer flexibility in borrowing. You could gain immediate access to funds while only borrowing what you need, with the ability to repay over time. This can be especially helpful for larger expenses you may not have fully saved for.

• Interest: You typically only pay interest on the amount you borrow, not on the entire credit limit, which could result in lower costs compared to other forms of credit.

• Revolving Credit: It can function as a revolving credit area, allowing you to borrow, repay, and borrow again as needed without reapplying for a new loan (assuming your financial situation hasn’t changed).

• Credit Building: Responsible use of a line of credit may help to build or improve your credit over time. Emergency funds do not have this benefit.

Disadvantages of Lines of Credit

• Interest Rates: Depending on market conditions and your creditworthiness, interest rates on lines of credit can be variable, meaning they may increase and lead to higher borrowing costs. 

• Note that Varo Line of Credit does not have variable interest rates, instead you pay a single one-time fee on the amount borrowed.

• Overspending: Easy access to credit can tempt individuals to overspend beyond their means, potentially leading to debt accumulation. Lines of credit require discipline to only spend as needed and to pay off your balance to avoid long-term debt.

• Risk of Reduction or Closure: Lenders may reduce your credit limit or even close your line of credit based on changes in your financial situation or their policies.

• Additional Fees: Some lines of credit may have fees associated with them, such as annual fees, transaction fees, or prepayment penalties, which can contribute to a higher overall cost of borrowing.

• Credit Score Impact: Mismanagement of a line of credit, such as late payments or high credit utilization, might negatively impact your credit over time.

When to Use an Emergency Fund vs Line of Credit

Now that we’ve gotten the pros and cons out of the way, let’s dive into when using an emergency fund could be beneficial, and when a line of credit may be a better option. 

When to use an emergency fund

In situations where you require immediate access to funds and value financial independence, using an emergency fund over a line of credit could be more beneficial. By relying on an emergency fund, you can address unexpected expenses without accumulating debt or incurring interest charges. This approach not only helps to avoid the burden of debt repayment but could also foster peace of mind during financial uncertainties. When facing unpredictable circumstances like job loss, or sudden expenses such as medical emergencies, having an emergency fund can provide financial security and resilience, offering a safety net that is readily available without the obligations associated with borrowing.

When to use a line of credit

There may be circumstances where a line of credit is more suitable than an emergency fund. In situations demanding immediate access to funds beyond what your emergency savings account covers, a line of credit could offer a quick solution. It may be beneficial for managing cash flow during temporary income shortages or tight financial periods. Additionally, when facing substantial expenses that surpass the capacity of your emergency savings (like major home repairs or vehicle maintenance bills) a line of credit provides a bit more flexibility. Finally, a line of credit could help to turn unexpected expenses into credit-building opportunities, with timely payments and responsible use.

Read more: Using lines of credit to pay off debt

5 Strategies for Effective Line of Credit Usage

If you decide to use a line of credit as part of your financial strategy, you could minimize the costs and avoid falling into a cycle of debt with responsible and deliberate credit line usage. Here are some strategies to follow.

• Calculate your borrowing capacity based on your own personal budget. Don't borrow more than you can afford to pay back.

• Set personal guidelines for when to use your line of credit, and stick to them.

• Have a plan to pay off your outstanding balance as quickly as possible.

• Consider setting up automatic payments to help keep yourself on track.

• Avoid using your line of credit for everyday expenses or luxuries. When possible, stick to emergency financial expenses.

We’re Here to Help You Build Your Personal Finance

At Varo Bank, we understand the importance of having a financial fallback option when you need it most. We offer a range of products and resources to help your emergency fund build faster while simultaneously providing customers with a personal line of credit to bridge the gap.

Our high-yield savings account makes it easy to grow your emergency savings with competitive interest rates up to 5.00% APY (Annual Percentage Yield) and no monthly fees. While you wait for your savings to grow, you may need a helpful lifeline to bridge the gap when unexpected expenses hit. That’s where Varo Line of Credit² comes in.

With Varo Line of Credit, you can:

• Borrow up to $2,000

• Pay a transparent, one-time fee (instead of paying recurring interest)

• Repay over the course of 3 to 12 months (depending on amount borrowed)

• No late fees, annual fees, or prepayment penalties

• Potentially grow your borrowing limit as you bank more, borrow more, and make on-time payments

Get started with Varo today or click to learn more about Varo Line of Credit!

^{1 Annual Percentage Yield (APY) is accurate as of December 11, 2024. Start earning 2.50% APY, then qualify to earn 5.00% APY on your balance up to $5,000.00 next month by 1) Receiving direct deposit(s) totaling $1,000 or more; and 2) End the month with a positive balance in all your Varo Accounts.}

^{2 The Varo Line of Credit is designed to help customers with unforeseen expenses with monthly payments, no late fee, no prepayment penalties, and no interest. To be eligible, your accounts must maintain a positive balance. Minimum monthly deposits, average daily balances, and other eligibility requirements apply. Once qualified for Varo Line of Credit, you will be assigned a credit limit from $600 to $2,000. A one-time fee is added to your borrowed amount, early repayment of your advance does not reduce the one-time fee. Your credit limit may fluctuate from one advance to the next based upon a variety of factors. You may only take one Varo Line of Credit out at a time. Your eligibility information and/or credit limit is always available to you in the home screen of your Varo app. Checking offer eligibility will not impact your credit score. If you are eligible and choose to apply for an offer, we will pull your credit and your credit score may be impacted.}

^{3 The Varo Believe Secured Credit Card is designed to help you build your credit; however, a variety of factors impact your credit and not all factors are equally weighted. Building credit may take time and Varo Believe may be able to help when you consistently make on-time payments.}