We’ve all heard how important it is to have an emergency amount of money set aside (saved) for those “unknown” expenses that can sometime hit our bank accounts. Generally, it’s recommended you have three to six months of your monthly expenses set aside in case of an emergency. Today, I want to recommend another type of account – a replacement fund.
A replacement fund is not an emergency fund. It is not, per se, a savings account. It’s an account where you save money for a bill that will eventually have to be paid. The purpose of a replacement fund is to set money aside for an item you will need to be replace in the future. Appliances, your heating/cooling unit, your vehicles, painting the exterior of your home, property taxes, or maybe you will have to update your windows or replace your floors. These things don’t last forever. They eventually must be replaced. While an emergency fund is based on the unknown, a replacement fund is based on the known.
A replacement fund calculates the known future replacement cost as well as calculating the monthly amount you need to make and how long you need to make it. The replacement cost is based on that item’s lifespan and adds an assumed inflation rate like 2%. It’s important to look at as replacement fund as a bill, not savings. You’re simply paying a bill ahead of time, little by little, a month at a time. It’s sort of like the old layaway plans people used to do before credit cards started dominating consumer spending.
I eat mine own cooking (advice) so here’s a real example. We replaced our home air conditioner in July 2020 for $7,500. While I hope it lasts longer, my research shows today’s ACs have a 12-year to 15-year lifespan. I used 12 years. I also applied a 2% annual increase in cost in my calculation which means if we save $66 per month in the Replacement fund for 144 months (12 years), we will have $ 9,512, the future cost of a $7,500 AC in July 2033.
You can apply the replacement fund concept to other items like your refrigerator, washer and dryer, a vehicle, or that exterior paint job you know you will need in a few years. You can do replacement funds for Christmas gifts, vacations, or planned home remodels. Again, don’t confuse a replacement fund with an emergency fund or a savings account. If you mix these all together, the lines sometime start to blur.
Here’s where to start. Pick one expensive item you know will need to be replaced in the future. Do the replacement calculation like the example above. Set up a bank account where you will systematically make that calculated monthly deposit. Once you get used to doing that with one item, pick out another large ticket item and repeat the process. You just need one bank account for your replacement fund. You can keep up with the balance of each item by using a line-item process.
Matt Montgomery has 39 years of experience as a financial advisor. Securities offered through Royal Alliance Associates, Inc. Member FINRA, SIPC. Advisory services offered through Matt Montgomery, a Registered Investment Advisor not affiliated with Royal Alliance Associates, Inc., 1504 East Rusk, Jacksonville, Texas, 903-586-3494. Mutual funds and exchange-traded funds are sold only by prospectus. Please consider the charges, risks, expenses, and investment objectives carefully before investing. A prospectus containing this and other information about the investment company can be obtained from your financial professional. Read it carefully before you invest or send money. * An Index is a portfolio of specific securities (common examples are S&P, DJIA, NASDAQ), the performance of which is used as a benchmark in judging the relative performance of certain asset classes. Indexes are un-managed portfolios and investors cannot invest directly in an index. Past performance is not indicative of future results.