The concept of a financial reserve will make or break your actual savings and financial goals. When you save money, it is set aside from your current spending. This savings could reside as cash or in your checking or savings accounts. However, what is this money’s exact purpose? If it does not have a very specific assignment, then any financial need or desire may consume it: a medical bill, car repair, attending an out-of-town wedding, replacing worn-out shoes, or used for being a tech ‘early adopter.’ Then, poof your savings are gone. So when a large expense comes along without savings assigned to cover it, the money to pay for that must be borrowed money. And borrowed money with interest charges turns you around in the wrong financial direction. There is one way to make sure this does not happen – it is to employ the concept of reserves.
A financial reserve refers to an assignment of money to serve a specific purpose. Simply living life requires many expenses, and many of these are known in advance and can be roughly estimated for both price and timing. For example, if you are currently driving a vehicle then it is a certainty that, sooner or later, it will require:
- Maintenance (oil & fluids changed, new tires, spark plugs, battery, brakes, wax and detail, etc.)
- Repairs (failed water pump, new muffler, or minor damage from a parking lot incident)
- Replacement (once your current car is no longer viable or serves your needs)
These three types of expenses are known in advance and can be estimated. We know today that we must pay for these expenditures, sooner or later. The way to prepare is to assign some of your ongoing additions to savings to: vehicle maintenance, vehicle repairs, and vehicle replacement. So when the brake light appears on your dashboard then you will have the money waiting on standby to pay for new brakes without going into debt or financial struggle. The rate of adding money to these vehicle reserves should be estimates based upon the age, type of vehicle, mileage, etc. For example, a brand new car will need no maintenance for a few years while a 15-year-old car will need a lot of repairs as parts fail.
If you fail to have savings assigned to vehicle replacement, what happens when your car dies? You make the financial mistake of a car lease or loan, making you poorer from interest charges. An accounting supervisor I spoke with did not understand this and was SO happy that she was just 3 months away from finishing off the car payments on her car loan. As kindly as I could, I pointed out, “You still have the vehicle expense for your next car. As long as you are using a car, your vehicle assets are depreciating and you have to replace that depreciation in an ongoing manner.” Sadly, she replied, “That is just for rich people, I can’t afford that.” I later learned that most of her family and relatives go from car loan to car loan, or car lease to car lease. Over their lifetime, they are transferring a huge amount of money to lenders, money that they could really use. And this extra expense is unnecessary: if only they would delay buying their next car until they could afford it from their car replacement reserve. If they could do this just once, and get ahead of their expense, then it would save them the remainder of their lifetime in car payment interest and extra lease fees. With one car replacement with cash, you can break the loan-to-loan cycle. This way, you will buy your subsequent car from building up your vehicle reserve and earning interest each month instead of paying that interest to a lender.
What are some other expenses, known in advance, that should have a reserve and a place in your budget? You may include medical bills, apparel, vacations, holiday gifts, home repairs, appliance replacements, emergency fund (for losing your job), and the big one: retirement. When you financially map out all of these potential expenses for the first time, it can be a shocking amount of money. True, but it is also the financial REALITY of your current lifestyle. You are viewing your financial life, in numbers, perhaps for the first time. These expenses can either be funded with savings up front or with debt after the fact. Which option do you think is best for your financial future? If you do not have reserves for those categories, when these expenses arise they will drain your “savings” to zero, and beyond.
More importantly, if you fail to reserve money for known expenses and your savings is constantly under pressure, then you will likely never have a meaningful amount of investments to fund your future. Having little or no investments will eventually translate into no retirement for you, or a retirement of financial struggle. My net worth did not start making notable advances that were sustained until I began fully reserving money for all of these known and common expenses. Use paper, a spreadsheet, or any manner to list out all your physical possessions and then estimate how much money is required for normal maintenance, repairs, and eventual replacement. For a simple example, if you’ll need to replace your lawn tractor in around 3 years, find the model you will want (and we’re estimating it may be $2,000) and divide that by 36 ( $2,000/36 months= $55), and you’ve calculated how much money you need to set aside in a reserve to replace your lawn tractor in 3 years. Your reserve list will have both dates and amounts for each item to replace, along with an estimate of annual maintenance and repairs until then.
If you want to protect your savings from life’s expenses, and thereby avoid unnecessary interest charges, then you must have allocated financial reserves. Setting up and maintaining these reserves needs to be involved in any budgeting or financial planning that you perform. There can be notable problems when you do not have specific reserves, in retirement for example. I know someone who retired with an imminent need to replace his dilapidated roof and one of his two cars – but his financial planner failed to point this out (and he didn’t ask me). So within one year of retiring, he was forced to go back and get part-time work, at a lower wage, to make payments for some of these obvious expenses where he had no reserve to cover them. It is my best advice that you begin to fund specific reserves for your lifestyle and refrain from spending that reserve on anything else.