Sometimes you just need more money—we all do sooner or later.
It could happen because you’re hit with a flood of very large and unexpected expenses. Medical bills, legal fees and major home repairs are some of the expenses that come to mind.
It can also come as a result of an income disruption.
The loss of a job, or of certain employment related income sources, such as bonuses, overtime or commissions. You may also decide to leave a steady job to start your own business and that will require money, not only for business investment but also for living expenses for the first few months.
At a time when credit is so available, there can be a temptation to tap credit lines to cover the losses. You might do that with the assumption that you’ll be able to pay them all back when your expenses have passed or when your income goes back to normal levels. But we should never assume that.
One of the problems with tapping credit to cover living expenses is that once you get comfortable doing it—or other options fail to develop—you run the risk of maxing out your credit lines. That’s easier to do than you might think.
Once you max out your credit lines, you’ll have a new set of problems to deal with.
Here is why maxing out your credit cards is a bad idea.
High monthly payment
The most obvious disadvantage to maxing out your credit lines is that as your loan balances increase, so will your monthly payments.
If you were easily managing $5,000 of credit card debt with a monthly payment of $100, you may find it much more difficult to pay $500 each month to cover $25,000 of debt.
Eventually, you might find yourself even borrowing on your credit lines to cover a monthly payment you can no longer afford out of your income. That will make matters worse.
The maxed out credit line no longer has any value to you
One of the biggest problems with maxing out credit lines is that once you do the credit line has no practical value to you.
It may have served your cash flow needs well while you were running up your balance, but now that there’s no credit available, you won’t be able to tap the line for more cash.
That maxed out credit line becomes a pure liability—with its attendant monthly payment—that gives you no benefit at all.
The effect on your credit score
One of the biggest factors credit reporting companies use to determine your credit scores is credit utilization.
That’s the percentage of your total outstanding debt to total available credit. The higher that percentage, the bigger the negative impact on your credit scores.
Generally speaking, credit utilization greater than 80% is considered a warning sign, and the higher it goes past that point, the lower your credit scores will be. One or more maxed out credit lines will have a dramatic affect on your scores.
Credit scores are not only important for borrowing, but they can also determine your ability to get a job, an apartment or even an insurance policy.
It will hurt your effort to get new loans
Apart from the impact maxed out credit lines will have on your credit scores, lenders look closely at credit utilization itself.
High credit utilization—or maxed out credit—is a major predictor of default. Maxed out credit means you’ll not only have fewer resources to deal with a cash crunch, but you’ll also have greater incentive to walk away from your loans.
Lenders are well aware of this, and may decline a loan application even if your credit scores overall are in an acceptable range.
The more credit lines that are maxed out, the less likely you’ll repay
High monthly payments, inability to access more credit, and a high likelihood that you won’t get fresh credit elsewhere may box you into a position where you’ll never pay the debt at all.
There is a “point of no return” that’s different for everyone, but it begins when too many credit lines are maxed out and the debts are simply too large to manage.
At that point, bankruptcy may be the only way out.
Loss of a source of emergency funds
Most people may not think of credit lines this way, but they can be a source of cash in an emergency. Yes, you should have a dedicated emergency fund in the form of a savings account or money market fund, but open credit lines can be a valuable second tier emergency fund for a serious crisis.
And let’s face it, even with an emergency fund in place you sometimes need to use credit if you can’t access a bank in time (we’re talking emergencies here).
When you max out your credit lines, you deny yourself access to additional funds in the event of an emergency.
When you consider all the problems that can happen when you max out your credit cards, you can see that the short term benefits of doing it are easily overwhelmed by what will come next.
Do your best to keep this from happening by setting your own credit limits that are well below what your card issuers allow. By doing that, you’ll keep your credit and your finances in good shape and insure that you’ll always have access to credit when you really need it.