How Does Liquidity Affect Consumer Payment Choice? 
The financial industry typically recommends that consumers have enough liquid savings to cover at least three to six months’ worth of expenses. However, the data show that the majority of US households are not prepared to handle financial emergencies. Indeed, using a recent representative survey of US consumers (the 2017 Diary of Consumer Payment Choice), the author shows that 25 percent of consumers have not saved any money for emergencies.
Emergency savings is an important topic in the literature on consumer financial decision-making, but a link to payment choice is missing. This paper adds to the discussion by analyzing how consumers’ emergency savings, or lack thereof, relate to their payment behavior. In particular, it focuses on credit card use and borrowing by consumers who have little or no emergency savings, people who are sometimes characterized as financially fragile.
Key Findings
- If faced with an unexpected expense of $2,000, nearly half of US consumers would not be able to cover it within a month, even if they could borrow on credit cards.
- Consumers who lack sufficient liquid assets to cover emergency expenses are much more likely to revolve their credit card debt—that is, to carry a balance from one month to the next—which can result in costly fees and interest payments. Those consumers already carry twice as much in unpaid credit card balances, on average, as the rest of the sample.
- Financial readiness varies widely across consumers, with lowest-income, least-educated, unemployed, and black consumers most likely to have $0 saved for emergency expenses and most likely unable to cover any portion of a $2,000 emergency expense.
- Even a temporary income shock, such as a layoff or a government shutdown, or an unexpected expense could lead to financial problems for consumers who are not adequately prepared.
Implications
The literature on emergency savings likely underestimates the financial effect of unexpected shocks, because it does not address credit card use and its associated costs. The literature does not take into account that consumers who have little or no emergency savings are more prone to revolving on credit cards and thus further weakening their financial situation due to the additional, high cost of such borrowing. Analyzing payment behavior in relation to unexpected expenses and emergency savings provides deeper, clearer insight into the financial situation of US households.
Previous studies find that consumption is sensitive to even temporary income shocks. The author uses panel data to examine whether consumers who experienced a drop in income from one year to the next, similar to one that could result from a government shutdown or job loss, increased their credit card borrowing. The author does not find significant evidence that such a negative income shock raises consumers’ likelihood of revolving on credit cards or increases the amount borrowed. This could indicate that consumers indeed reduce their consumption when their income drops, rather than borrow more on their credit cards.
Abstract
We measure consumers’ readiness to face emergency expenses. Based on data from a representative survey of US consumers, we find that financial readiness varies widely across consumers, with lowest-income, least-educated, unemployed, and black consumers most likely to have $0 saved for emergency expenses. For these consumers, even a temporary financial shock, either an unexpected negative income shock (such as a layoff or a short-term government shutdown) or an unexpected expenditure (such as a medical expense or a car repair), could have severe financial consequences. The literature likely underestimates the consequences, because consumers who are not financially prepared to cover unexpected expenses are more likely to borrow on their credit cards, adding to their existing debt. Thus the cost of relying on credit cards is likely very high for consumers who are already financially vulnerable. We use panel data to examine whether consumers who experienced a substantial drop in income from one year to the next, like one resulting from a layoff or a government shutdown, increased their credit card borrowing. We do not find evidence that a negative income shock raises consumers’ likelihood of revolving on credit cards or increasing the amount borrowed.