Friday, May 23, 2008

Budgeting for Unexpected Expenses

Unexpected expenses are just an expense with uncertainty attached

Unexpected expenses can really hinder your saving or debt repayment efforts. You have your budget carefully planned and meticulously detailed and thought out. Then, out of the blue, pops an annoying significant and unexpected expense and re-shuffles everything.

I’ll be arguing further along this post that all unexpected expenses are really expected costs with an attached element of uncertainty. This is a powerful claim which I believe to be true. Hopefully by the end of this post you will agree.

Not all unexpected expenses were created equal. I like to think of a hierarchy of unexpected expenses and in the following I will present my hierarchy of costs and how I budget and plan for these.

#1 “Is it Christmas already?” – Seasonal recurring expenses

When it comes to the first type of unexpected expenses, such as holiday presents for example, the case is clear. These are obviously expected costs which were not planned for. This usually happens in budgets that are planned as averages while ignoring seasonality, or peaks and lows in certain months.

Holidays are a good example since they usually happen, and even more surprisingly, they arrive at the same time every year. Humor aside, an occurrence with a probability of 100% cannot be titled “unexpected”.

Adjusting you budget to seasonal variability is a good idea which will help avoid sudden expenses which should have been planned for. Among seasonal expenses are:

  • Holidays

  • Annual or semiannual subscriptions of all sorts (magazines, health clubs etc.)

  • Taxes, tolls and fees

  • Insurance

  • Travel and vacations

  • Tuition

  • Etc.

All of these should by no means surprise you as they are bound to happen and are easily incorporated in an annual adjusted budget. Average is a good tool but it should be used appropriately.

#2 “The neighbor’s son is getting married”, “The car’s broken again” or “The walls are leaking” – Surprises

Moving on we find some of the most annoying expenses of them all: a car malfunction, plumbing problems, dental care and more. These expenses will occur, the question is how often will these occur and how much will they cost?

Referring back to probability these expenses will occur at a certain probability, smaller than 100%. The probability of these unexpected expenses differs from person to person or family to family. Research shows the average annual spending on this sort of expenses is approximately $2,000 per family.Source:

There’s no sure way of estimating these costs. Only you know your own personal circumstances and your family. However, there are a couple of pre-emptive steps to take in order to expect the unexpected:

1. Budget for the unexpected – Since we foresee these expenses will eventually occur at a certain frequency and volume we can and should budget for them on a timely basis (I do it on monthly basis).This method has two distinct advantages: You won’t be surprised and hard pressed when you suddenly need a new car battery and more importantly should frequency and volume be surprisingly low you’ll be able to save that amount, increasing your emergency fund (step 2).

The temptation to consume these funds is great. However, keep in mind that on average these expenses will occur eventually.

2. Emergency Fund – There have been a lot of words written on emergency funds and their importance should be clear by now. It’s a method of expecting the unexpected and a very important pre-emptive measure towards more pressing times. Should nothing surprising happen you’ll have a healthy saving generating solid interest.Two great articles on emergency funds can be found at The Digerati Life and The Simple Dollar.

#3 “Can’t we postpone the birth for a couple of months?” – Life events

Life events tend to surprise us with their financial impact. Whether it is buying a house or having a baby we are often caught unaware and unprepared to handle the financial aspects of these life events.

The events themselves are usually planned and thought out but their meaning and significance hasn’t been all that clear while making the initial decisions.

Home buyers are always surprised by the deal costs. New parents are often awed when facing the harsh reality of how costly another family member is (wait till you have to get him or her through college and maybe help out with an apartment). This post by Moolanomy demonstrates this point beautifully (10 ways new parents overspend on their newborns).

These unexpected expenses are usually a result of relative ignorance and lack of proper research. There is a wealth of information available on line for all of us to research and use for our financial and life planning.

Taking the time to properly plan an annual and multi-year budget is crucial. This multi-year budget should take into account our life plans and events and should be used as an integral tool in our decisions making.

#4 Accidents, disability, mortality or longevity

The broadest and maybe most important type of unexpected expenses are the ones that impact our ability to generate income and support the ones depending on us.

Accidents, disability, mortality and longevity (surprising but true) all significantly or totally lower our ability to maintain the level of comfort we have been used to. These events are unexpected in nature but have a certain probability of occurrence. Accidents and disability significantly change our lives, mortality is self-explaining and longevity has the risk of turning us into a liability on our children’s lives.

There is no real way to budget for these occurrences. What do we have left in our arsenal of pre-emptive measures? Insurance.

Insurance is basically transferring our specific risks to the community for a premium. For a certain premium which is carefully calculated according to the risk of a certain occurrence we can assure ourselves and our families a steady and good life even should the unfortunate happen.
Disability Insurance, life insurance and retirement planning are all integral parts of planning for unexpected expenses in the “life” level.

Hopefully I was successful in my mission of explaining my view of unexpected costs. I’d be very happy to read your point of view and thoughts on the matter.

Image by: Pulpolux


annie said...

Loved it! Thank you! I have areas in my budget for holidays, birthdays, professional dues, yearly insurance premiums- and it has completely changed the emotional reaction to getting those bills in the mail.

Dorian Wales said...

@Annie - Thanks for the feedback. It really means a lot.