Many people have a budget and use it to control their monthly spending and make sure that they have all of the money needed to cover everything. But they still get into trouble over time because of the big expenses that come up: The car replacement, the new roof, the AC, even a vacation. Today we’ll talk about creating a Big Expense Fund to be ready when things in life happen.
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You Have a Budget
If you’ve been doing financial management at all in your life, you already have a budget. Here you look at the cash coming into your life through work and other sources and all of your bills and make them match. If needed, you cut back on things that you can until you have balanced income and expenses. If you are doing this, you’re already way ahead of a lot of people. Your life is easier as a result.
In addition to having a budget, you need to have a way to make sure you follow your budget. One way to do this is to simply pay for the important things first – the rent or mortgage, the utility bills, food for the house – before you buy other things. You can also use a budgeting app that keeps track of what you are spending in each category and warns you when you’re running out of money for that category. For example, if you’ve allocated $500 for eating out each month and you’ve already spent $450, you can see through the app that you only have $50 left and maybe get pizza instead of a full sit-down meal. People also use envelope systems where they put cash for each category in envelopes and then only spend cash in each envelope for the specified purpose.
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But having a budget will not be enough to to make sure everything goes smoothly. You will still have times when there are bills you cannot pay. You will also still end up spending more for things than you need to if you use a simple budgeting hack. Think of it as going “next level” on your budget.
Why a Budget Isn’t Enough
So, why is having a budget not enough? A budget takes care of the regular expenses. Food for the month, Clothing you need and that wears out regularly. Small things.
The issue is that there are big things that break and need replacing when they do. Your car dies and you need a new one. Your refrigerator stops working and you need to get it replaced. Things happen like a pipe breaks and you need to get a plumbing repair that runs into more than $1000.
These types of big expenses will come up from time-to-time. If you aren’t ready, you’ll need to get a car loan or a line of credit. Maybe you’ll need to use a credit card or get a payday loan. All of these things will cost you interest. It may also require you buy something more expensive than needed, like a new car from the dealer instead of a used one from the guy down the block.
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Setting Up a Big Expenses Fund
To cover these types of expenses, you’ll need a Big Expense Fund, or BEF. A BEF is a pot of money you keep ready in case there is something big that comes up. That way you’ll be ready when they do.
Note that these aren’t unexpected things. You know that your car will eventually die or that the oven will go. It’s just that you don’t know exactly when they will occur. And when they do, it usually happens pretty suddenly, and often at the worst possible time.
Still, while you don’t know exactly when you’ll need to pay out a big expense, you can estimate how long it will be before you will need to replace something. Your car will probably last somewhere between 150,000 and 300,000 miles, depending on what kind of car it is. If you’re driving 15,000 miles per year, that’s 10 to 20 years from new. You may also decide you want to replace your car sooner than this.
Your roof will last 20-30 years from new. Your refrigerator and other major appliances will probably last 4-8 years these days. Everything has an expected lifetime, allowing you to estimate how long it will be until you need to replace it. Make up a list.
Once you do, put an estimate for what it will cost to replace the item. Do this for all of the items, then divide the cost by the number of years until replacement. This is the cost per year to replace these items.
Add all of the costs per year up, divide by 12, and that is how much money you should be putting away each month to replace your items into your BEF. If you start to put away money into savings to replace these items each month, or maybe a few times a year when you have extra cash if your budget is tight, you’ll have the money you need for replacing things within a year or two. Note that because you are putting away money for things that won’t need replacement for many years, you’ll have enough money to replace some things that break sooner than expected. (You just need to hope nothing big breaks until you’ve saved up enough and are ready).
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Yes, You can Invest It, Maybe….
You should soon build up quite a bit of money if you’re putting away cash for all of your expected repairs in your BEF. It seems like a bit of a waste to have all of that money in a savings account, earning low rates of interest. Can you invest some of the money?
The answer is yes, maybe. Realize that money invested in stocks that is needed within 5 years or less could see a drop in value and not recover by the time the money is needed. Even less than 10 years is a risk.
But if the amount of money you build up in your BEF is at least twice any of your big expenses, and especially if the biggest expenses are still a long time off, you can probably go ahead and invest the money as you wait. In doing so, returns on your investments will likely make it easier to cover the big expenses since you won’t need to generate all of the money yourself from working. A 50% drop in the markets is very rare, so you’ll still be covered should this very rare event occur. You can also take opportunities to set aside cash when you see big upward movements in the markets when you’re within a year or two of needing the cash for something.
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How to Invest
If you are going to invest the money, a diversified portfolio of stocks and bonds is probably the best way to go. This is most easily and cheaply done using a set of index funds. For example, you could use a total stock market index fund and a total bond market index fund. The percentage you put into each would depend on your personal tolerance for fluctuations in value and how long you’ll be able to invest before the money is needed. Of course, putting aside cash for things you know you’ll need within a year or two would be wise to avoid needing to sell stocks and bonds when the markets are low.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
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