Finance 101, Uncategorized

How to amortize your expenses (and why you need to)

Amortizing personal costs prepares you for these large expenses by having cash on-hand when they come due.  It also keeps your budget realistic.  For a budget to be useful, you need to account for all your expenses, even the ones that aren’t actually due every month.  Amortizing is also the way to incorporate surprise costs into your budget!

The goal of a budget is to help you manage your money better.  The best way to manage “surprise” expenses or irregular payments is by incorporating them into your budget with amortization.  For surprise expenses, this means setting up a savings account for things like home and car repairs.  For non-monthly payments, like insurance premiums due every six months, this means amortizing your payments.

What is amortizing?

Amortizing, in personal finances, is basically offsetting a cost by setting aside money regularly.  Loan repayment is amortized, as you are expected to make small payments regularly instead of paying off a huge chunk of cash at once!

In business, amortization can refer to writing off an asset cost over a period of time.  The principle is the same – you have a large or irregular expense, so you spread out the cost over a long period of time.  This requires making monthly contributions towards the cost.

Why should I amortize personal costs?

Amortizing personal costs may look like saving up for a an upcoming insurance premium, making monthly payments on your mortgage, or splitting up a big cost over several months in your budget.

If you sign up for car insurance, and the premium is only due once a year, it’s easy to pay the initial fee and forget about it.  Then you get surprised with a big cost when the premium comes due next year!

A wise budgeter plans for this expense.  In my free budget download, there is a row each month for car insurance, renters/home insurance, and life insurance.  We choose to make monthly payments toward these expenses so that we are prepared to pay them when they come due every six months or year.

How do I amortize a cost?

Amortizing is so easy.  The key is to think of large or yearly expenses in terms of a monthly payment.

You just need to find the monthly payment for the cost!  The formula is simple-

Monthly payment = total payment cost / months between payment

You just take the total amount due, and divide it by the number of months between payments.  There is a handy amortization calculator built right in to my free budget download!

If your payment is due every year, that’s 12 months.  Easy!

If you have a car insurance policy that has a $635 premium due every six months.  Your formula looks like this:

$635 / 6 months = $105.833333…..

I always round up to the nearest dollar.  Better to save too much than not enough!  So your monthly payment is $106 a month.

What do I do with my monthly payment?

Instead of making monthly payments to your insurance provider or to amazon for your prime membership, you make payments to a separate savings account that is set up to hold funds for these yearly payments.  This should be an account that is not attached to your regular checking account.

The idea is to have this money out of sight and out of mind.  I recommend using a high-interest savings account!  You can read more about how and why to use a high-interest savings account here!  Basically, it means your savings earn you a little extra money.  Who doesn’t like extra money?!

What expenses should I amortize?

Any expense you don’t pay every month should be amortized.  This includes

  • Payments to savings (especially your emergency fund!)
  • Insurance premiums (car insurance, home insurance)
  • Yearly memberships (amazon prime)
  • Family memberships or passes (zoo passes, AAA)
  • Holiday funds (Christmas, birthday, Halloween…)
  • Taxes (if they aren’t withheld automatically)
  • Home or car repairs (set up a car maintenance savings fund for anticipated expenses!)

How do I amortize for Christmas and other savings?

Amortizing for holidays requires you to have a set budget for birthdays and holidays.  I highly recommend this, as it keeps you from overspending!  Amortizing these costs over the year prevents you having an expensive Christmas, and a sad January paying off your credit cards.

In our family, we budget $100 for each kid at Christmas, and $100 for birthdays.  My husband and I get $60.  This is our budget for everything – stocking stuffers, birthday cake, special birthday dinners, and gifts.  Our kids are little, so we don’t budget for parties right now.

The reason our budgets per person are so small, and why we include ALL our holiday costs in it, is really is a post for another time, but I will say that LESS IS MORE.  Trust me, your kids do not need $500 worth of toys twice a year!

I’m going to show you how this works in a simplified example.  We also budget for family gifts, mothers day and fathers day cards, Christmas cards, and other holiday expenses.  We find the “holiday budget” grows every year as we find new things to add to the category (Easter candy, anyone?).  That’s a little overwhelming, so I’ll talk about how it works with just our birthday and Christmas money.

The way to amortize for savings is the same as amortizing expenses – just take your total savings budget and divide by the months between.  In this case, we just budget for the whole year.  Our total gift budget per kid each year is $200 (remember – $100 for birthday and $100 for Christmas) per kid, and $120 for my husband and I.  For the whole year, that looks like this –

$200 + $200 + $120 + $120 = $640

Using our amortization formula, we get

$640 / 12 months in a year = 53.3333…..

Again, I like to round up, so we would pay $54 each month to our holiday savings account!

How do I use an amortized savings account?

It can seem a little confusing to put money in each month, especially if you need to use the money on someones birthday.  Here’s how I do it!

1. Keep track of holiday or birthday expenses

I track everything that I buy for a holiday or birthday separately from my regular budget.  At the end of the birthday/holiday, I have a total amount I spent on that birthday.  At the time of spending, these expenses just come out of our regular checking account.

2. Make your monthly amortized payment like normal

Even if it’s December, make your monthly deposit!  It’s really best to have these deposits automated so you never forget.

3. Pay yourself back at the end of the month

At the end of the month, total up all your holiday and birthday expenses.  The money has probably been coming out of your regular checking account, so now you need to pay yourself back from the holiday fund!

Just withdraw the total amount you spent on holiday/birthdays and deposit it back into your checking account to replace the funds you used!

Alternative method: cash

If this seems to complicated to you, there is any easier way!  We prefer to do everything online so we can use our credit cards and earn points, but you can totally make this work with a cash system.

Simply withdraw the budgeted amount from your holiday fund before a holiday/birthday!  When the cash is gone, it’s gone.  No expense tracking.  Easy!

This method only works if you have been saving for several months.  If we were to start saving in January, and spend $100 on our son’s birthday that same month, we’d be in trouble!  There would only be $54 in the savings account – not enough to cover expenses.  Make sure you start saving enough in advance to have enough  cash saved for the next holiday or birthday!

After about a year of making regular deposits, you should have a self-sustaining fund that always has enough to cover your holiday expenses!  Remember that you must continue to make regular deposits or these funds will just get used up!

Summary

Amortizing personal costs helps you create a more comprehensive budget.  Using a high-interest savings account to store your monthly payments can help you earn more off of this money, while keeping it on-hand when the payment comes due.

Prepare for emergencies, large yearly payments, and memberships by paying for them monthly, and your wallet will thank you!  No more months where your budget is eaten up by insurance!

 

Do you save for birthdays and holidays?  What expenses could you amortize?

Amortizing for beginners

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