Are you assuming that things will go along pretty much okay? Most people do, and they're usually right. Even when they're wrong, it tends to be okay, because the typical household's finances can absorb the occasional small blow. But sometimes the blows are medium-sized or large. What do you do then?
I've written before about handling the large financial blows. (In particular, I've written about losing a job and about moving your household finances to an emergency footing.) Dealing with the medium-sized blows is easier, but at least as important. After all, they're more common.
Sometimes the blow falls on the income side: Wages or salary cut, hours cut, an expected raise or bonus deferred or canceled, falling interest rates or dividends (a big deal for those living on capital). Other times on the spending side: Unexpected expenses, rising prices. So, how do you handle problems of this sort?
Well, the short answer is that you handle them in the obvious way. In the very short term you dip into your emergency fund, cut back on savings (or cut back to the minimum on repaying debt), or even borrow money. Then, in the medium term, you hustle to boost your income and take steps to cut your spending until things are back in balance (and you can replenish your emergency fund and resume normal saving or accelerated debt payments).
The longer answer, though, is that it's worth having a plan — because taking one of these medium-sized blows to your home economy can prompt you to make unwise decisions when you try to play it by ear.
We just had a good post on making an emergency plan for how to hold your emergency fund, how to access it in the case of an emergency, and what steps to take if the emergency outstrips your funds. The distinction here is that not all contingencies are emergencies. In fact, the whole point of a contingency plan is to keep contingencies from becoming emergencies. That's why it's worth going to the trouble of making a plan now, rather than waiting until it's an emergency.
Make your plan
Everybody's budget is a compromise between the cheapest way you could meet your actual needs and the most luxurious way you could satisfy your slightest whim. But there are many, many decisions embedded in that compromise. A contingency plan makes those decisions explicit, so that you know which dollars are going to the least important wants. Then you know where to cut when you get hit with falling incomes or rising costs.
As a bonus, actually making a plan informs your long-term commitments. Imagine that before you took out a car loan or signed a lease, you rejigged your contingency plan to allow for the new fixed expense. Seeing exactly which expenses might have to be cut if your finances took a hit might make you reconsider.
Strategies for implementation
Things change, so you don't want to just blindly follow a contingency plan that you made months or years ago.
Especially in the case where rising costs for specific categories are the problem, one thing to do early is to look at cutting those very costs. If the problem is rising food prices, take a fresh look at what you're buying at the grocery store — it's rare for all prices to go up the same. If the problem is rising fuel prices, take a fresh look at thermostat settings, at combining trips, carpooling, mass transit, etc.
Of course, at some level you ought to be doing this all the time. But once you've done it once (taken a serious look at where your spending is going and compared it to where you get the most satisfaction), the payoff to doing it again is going to be smaller. But when things are changing — especially when things you buy are rising in price faster than things you don't buy — it's worth doing again.
Probably the most common element of a contingency plan is simply deferring expenses. In many cases you can (temporarily) make do with what you've got, freeing up the portion of your budget that would have handled upgrades to cover contingencies.
Thinking about these things in advance makes it a lot easier to adjust smoothly to the little financial glitches that we all face.
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