Defining Unexpected Expenses
Redefining your notion of unexpected costs can help you plan
Conventional wisdom says that the money in your emergency fund should be earmarked for "unexpected expenses."
That's true. But what, exactly, is an unexpected expense?
Here's what it's not:
It's Not Recurring Annual Bills
Your property tax bill, car insurance bill, annual life insurance premium, eyeglass exam, and other once-a-year expenses are not unexpected. On the contrary, you can fully expect to pay these bills annually or semi-annually.
Budget for these by setting aside a fixed amount each week or each month. If your property taxes are $5,200 per year, for example, set aside $100 a week. If your eyeglass exam and lens replacement cost $300 each year, set aside $25 per month. These are not the types of expenses that your emergency fund should be used for.
It's Not Occasional Maintenance or Repairs
Is your roof leaking? Did your dishwasher break? Do you need to pay a $1,000 health insurance deductible?
Most people would call these unexpected expenses. But some personal finance experts disagree.
"Medical bills, car expenses, and home costs aren't unexpected — at least they shouldn't be," says Liz Weston, a personal finance columnist for MSN Money and the author of the book The 10 Commandments of Money. "If you have a body, a car or home, sooner or later it is going to cost you."
What she means is that your budget should include an estimate of how much you'll spend on variable costs like home, car and health issues.
For example, One good rule of thumb is that 1 percent of your home's cost should be set aside each year for home repairs and maintenance. If you live in a $250,000 home, you should save $2,500 per year or $208 per month.
You won't spend $2,500 every year. Some years you'll spend just $100 or $200 on basic maintenance, like cleaning the gutters. But other years you'll spend $7,000 replacing the roof. The 1 percent rule of thumb is intended to be a long-term annualized average, and you can budget for these types of expenses by setting aside $208 per month in a "home repairs and maintenance" fund.
The same is true for car and health expenses. You may choose to set aside $600 a year, or $50 per month, for car repairs. Some years you'll spend $0. Other years, you'll need to fork over $4,000 to replace the transmission. Budget yearly to "even out" these wild swings.
Similarly, you'll need to set aside some money each month to cover deductibles, co-pays, prescriptions, and other out-of-pocket medical costs. The amount you set aside should be aligned with the deductible and maximum annual out-of-pocket costs on your health plan.
For example, let's say your health plan has a $1,200 annual deductible and $5,000 total annual out-of-pocket maximum. If you're healthy and don't visit the doctor often, you might decide to set aside $100 per month, or $1,200 per year, into a health savings account. If you think you may need more frequent doctors visits, you might opt to set aside $416 per month, or $5,000 yearly (the full annual out-of-pocket maximum).
So What Is Truly Unexpected?
Your emergency fund should be used for expenses that fall outside the categories of "annual bills" like property taxes, optometry, and car insurance. It should also be used to pay for bills that are outside the purview of home and car maintenance and repairs, and normal health-related bills.
Truly unexpected expenses are the result of events like losing your job or getting struck by a massive, out-of-the-norm health-related bill that insurance won't cover.
Redefine your notion of "unexpected" bills to encompass these once-in-a-lifetime events, rather than more common activities. Then adjust your budget accordingly.