“Spending Shocks” are large, irregular expenses. According to CBS, more than 60% of Americans cannot absorb a $500 spending shock: spending shocks are the #1 reasons why budgets end up abandoned, and being prepared for large spending shocks is the best thing you can do to keep your personal finances healthy.
Types of Spending Shocks
There are two types of spending shocks: Budgetable and Unbudgetable.
Budgetable Spending Shocks
A “Budgeted” spending shock is a big expense you might only see once or twice a year, but you know it is coming well in advance. This includes things like buying gifts for birthdays or holidays, regular trips to the dentist, and shopping for school supplies.
Budgeted spending shocks, in theory, are easy to manage, since you can include them in your monthly spending plan or budget. Unfortunately, most people do not revise their budget or spending plan each month, so even expenses that you can expect well in advance can really hurt.
Unbudgetable Spending Shocks
These are unplanned expenses that you do not see coming. This includes things like car repairs, fixing a broken computer, or replacing lost/stolen items. Unbudgeted spending shocks can be devastating if you are not prepared, since they also tend to be very expensive.
Preparing for Spending Shocks
In a perfect world, there would be no “budgetable” spending shocks, since these would already be in your monthly budget. We do not live in a perfect world, so we need to be prepared for these shocks to keep them from wrecking our savings goals.
Method One: The Rainy-Day Fund
The first approach is building your own “insurance policy” in the form of a rainy-day savings fund. This is a specific amount you can put into a separate savings account, and keep it topped up with something between $500 and $2000, depending on your income.
This account does not count toward your savings goal, nor should it be money used as part of your normal cash used day-to-day. Your goal for this fund is to keep the balance constant, acting as a cushion for spending shocks that break your budget, but before it can damage your savings. The idea behind the rainy-day fund is that you already know these spending shocks will happen, so you have an “emergency reserve” stash of cash that you can add into your budget if needed.
Once you get an unexpected car repair bill for $250 that you cannot absorb with your regular budget, you can withdraw the $250 from your rainy-day fund. Now, in addition to your normal monthly savings goal, you need to add that $250 back to your rainy-day fund to make it whole. Once you’ve replenished your rainy-day fund back to its constant level, your budget returns to normal.
Method Two: Emergency Credit Card
If you have trouble squirreling away cash, your next option is having a second credit card specifically for emergencies. This credit card may or may not even be in your wallet – you may instead keep it locked up in a safe place at home. This will help prevent its use for any impulse purchases.
If you do get hit with a spending shock that breaks your budget, you can take advantage of this credit limit to cover the balance. This works a bit like the inverse of the rainy-day fund – your goal is to keep this credit card’s balance at zero.
If you do need to use the emergency credit card, you should never make the minimum payments. Once you set aside your normal monthly savings and pay off your normal bills, use as much of the remaining cash as possible to pay off your emergency credit card. This not only helps prevent interest charges, but it also restores that credit limit in case of another spending shock.
Method Three: Borrow from Savings
The last, and worst, method is borrowing directly from your savings to pay for the spending shock. In this case, if you are hit with a big spending shock, you make a transfer from your savings account to your checking account to pay it off. In the next few months, you pay back this loan, in addition to your normal monthly savings.
This works like the rainy-day fund, but without separating the “emergency cash” from your normal savings. This is a more dangerous method because it lets you avoid “paying yourself back”. Making withdraws from your regular savings account should be avoided whenever possible because it is so easy to forget how much you need to return, and on what time schedule. With the rainy-day fund or using an emergency credit card, you will always see the exact amount you need to pay back, which helps stick to the plan. Withdrawing from your savings directly just lowers your nest egg, and you may not realize the full impact until many years later.
Avoiding Spending Shocks
You can avoid most spending shocks with a bit of planning. By taking 20 minutes each month to do a basic account reconciliation and taking a look at your receipts, you can update your budget or savings plan and know exactly what shocks are coming soon. Getting any “budgetable” spending shocks figured in to your normal budget is a great way to stay on top of all your finances.
You can never truly prepare for the unbudgetable spending shocks, but taking a few minutes every couple of months to just check the status of things you own can help. If your car is making a weird sound, it will be a lot cheaper to budget in a mechanic check-up next month than it would be to pay for an emergency repair. If you own your home, taking a few minutes twice a year to check the roof for leaks will be far cheaper than finding mold and having to gut half the house.
Think of some of the most devastating spending shocks that could happen, then schedule appointments for yourself in your calendar to give yourself a check-up. Preventing emergencies is always cheaper than fixing them later!
This lesson is part of the PersonalFinanceLab curriculum library. Schools with a PersonalFinanceLab.com site license can get this lesson, plus our full library of 300 others, along with our budgeting game, stock game, and automatically-graded assessments for their classroom - complete with LMS integration and rostering support!Learn More
- What do you understand by the term Rainy-Day Fund or otherwise known as an Emergency Fund?
- How would having a Rainy-Day Fund be beneficial for you and your family?
- Opportunity costs, is the cost of choosing one thing over another. How might this concept benefit you when spending?
- How might regular budgeting and spending assessment help you with your cash flow and savings?