Every once in a while, I’ll get an email from a reader that goes something like this…
This month, my annual insurance bill came due and I couldn’t make ends meet. I cleaned out my emergency fund. Then, at the end of the month, my car broke down. What’s the point of having an emergency fund? I’m in debt anyway.
The issue is this: an irregular bill that you know about ahead of time, such as your annual insurance bill, is not an emergency and shouldn’t tap out your emergency fund.
Emergencies are things that you did not know were coming, such as your car breaking down, a parent or a child or you getting sick, a tree falling on your house, and so on. An emergency fund is money you set aside for things you didn’t know were coming.
Irregular bills are expenses that you know are coming but may be a long way off, like an annual insurance bill or a tax bill. These aren’t emergencies, so you shouldn’t use your emergency fund for them.
Why shouldn’t you use your emergency fund for these things? The big reason is that when you drain your emergency fund for non-emergencies, you leave yourself exposed to actual emergencies. Anyone who has ever experienced Murphy’s Law knows exactly what I mean here. You tend to find yourself needing something just as soon as it’s not there.
How exactly do you handle irregular expenses, then? I use a handful of techniques.
First, I try to pay for irregular expenses out of my regular budget. My monthly budget is pretty flexible, with the excess mostly just being dumped into our savings for our dream home. If I can, I just pay for irregular expenses out of my checking account so I don’t have to worry about it.
Second, I actually save for such expenses. I have an Excel spreadsheet where I keep track of all of the irregular bills I cover and how often they occur. I total up how much these will cost me over the next year, divide it by twelve, and find myself with an amount that estimates how much I’ll need per month to pay for all of these irregular bills. On top of that amount, I usually add about 25% to help with bills that come up sooner rather than later.
I then set up an automatic savings plan with my bank to move this amount into my savings account automatically each month. I have a savings account specifically for such purposes. Then, when I need to pay an irregular bill, I just take money out of that account to pay for the bill without any real worries.
Yes, over time, that account builds up some excess money. That’s fine. It helps me in the event that there are irregular bills that I’ve forgotten about.
So, let’s say I have an annual insurance bill that’s $1,200 a year, a semi-annual insurance bill that’s $450 every six months, and another bill that’s $200 every three months. That’s $1,200 plus $900 plus $800 per year, a total of $2,900. I divide that by twelve, giving me a monthly amount of $241.67. I add on an extra 25%, which gives me a total of $302.08 per month.
So, I just set up an automatic transfer of $300 per month into a savings account. When those big bills come in, I’ve got enough in that account to cover them.
I recalculate this every time a new bill pops up or a bill ceases to exist, so that I know how much I need to pay in the current situation. I then, of course, adjust my automatic transfer as well.
If I find myself in a situation where this plan doesn’t work, then I’ve got a real problem on my hands. Yes, I’ll pay the bill, but not being able to handle such a known bill means I need to spend some time re-evaluating my financial planning. Why did I miss this bill? How can I make sure I don’t miss it in the future?
To put it simply, it’s a bad financial move to not be able to handle an expected bill, particularly when it forces you to tap your emergency fund. Plan for it now so you’re not hurt by it later.