If you own physical assets like cars, computers, washing machines, dishwashers, etc, you will gain a great deal if you learn how to calculate depreciation . This isn’t just a concept for your accountant to nail down. It is a very important tool if you want to have financial security. Fortunately, it’s not all that complicated.
What is depreciation?
Depreciation is simply recognizing that physical assets wear out over time. I am not talking about financial tax planning and the IRS rules regarding depreciation. I’m talking about the reality of it.
If you own a home, think about your roof. Sooner or later you’re going to have replace it. If the roof costs $10,000 and you can expect it to last for 20 years, your roof drops $500 in value every single year. That loss in value is the depreciation. And that means your roof costs you $500 a year.
Why is depreciation so important?
Because people forget about it. Did you look up at your roof on January 1st and calculate the depreciation over the last 12 months? Probably not. Very few people think about their assets this way. And that’s why they are thrown for a loss when the asset has to be replaced one day and they have to come up with $10,000 they don’t have.
This leads to stress and worse. It often results in you having to scramble to find the money to replace an asset immediately. That means you might end up paying higher interest rates on borrowed funds. Not a good tone if you ask me.
This is a great financial error that most people I know make – they forget to make allowances for depreciation.
How can you solve this problem?
You can take two steps to insure that depreciation doesn’t throw you for a loop. First, list your major assets on a spreadsheet like this:
As you can see, all you have to do is figure out what it will cost to replace the asset (column B) and by when (column C). Of course you can’t be exact because you don’t know what the “thingy” is going to cost and you don’t when the “thingy” will wear out. But do a bit of research on the internet and take your best guess. This is far better than doing nothing.
Next, divide the replacement cost by the number of years until you have to replace it. That is your annual depreciation cost (column E). To work out your monthly depreciation cost, simply add up the total like I did in column F.
At this point, you know what your depreciation expense is for all your “stuff”. That’s better than 99% of the people out there so congratulate yourself with a double scoop of chocolate ice cream – my favorite. But let’s not stop there.
Your last step is to set up an automatic savings deposit for this amount. I suggest you set up a separate savings account using a company like Perkstreet which is an online bank. They can help you set up your online account with automatic deposits. It won’t cost you anything and they have no minimum account balances. Nice.
Every time one of the listed assets needs to be replaced, use this fund to defray the cost. If you are fortunate, you’ll have enough saved up for each asset. Even if you don’t have all the money you need to replace the asset, you will certainly be better off than if you hadn’t set up this sinking fund.
Depreciation is an expense you incur every single day. Most people don’t recognize it until it hits them in the face and that usually ends up costing them more money and heartache. Don’t let that happen to you.
How do you deal with depreciation? Have you set up a fund for this? How is it working so far?