It would be nice to think that we all could be so frugally minded that no significant expenses would ever pop up. Unfortunately, no matter how much we want to save money and live frugally, major expenses are simply a part of life.
However, that doesn’t mean we should wait around for them to come and then pay a huge expense all at once. Planning for these significant expenses can make them far less painful when the time comes to pony up. This is where the idea of a sinking fund comes in handy.
What Is a Sinking Fund?
A sinking fund is a money you put aside for a future expense. The expense can be anything. Vacations, new cars, a new home, holiday gifts, you name it, you can have a sinking fund for it. The idea is to save money a little bit at a time to either soften the blow when the expense comes or, better yet, have it covered completely.
Related: Start Making Better Investments With Your Money Today
Why Is It Called a Sinking Fund?
The term sinking fund doesn’t exactly instill confidence or planning ahead, so why is it called that? Traditionally, sinking funds are associated with the corporate world. The sinking fund here refers to money set aside by a company to pay off long-term debt like bonds.
The “sinking” part refers to the amount of debt still owed as it gets paid off. The money put aside “sinks” the company’s debt, so a “sinking fund” is born.
Why Do I Need Sinking Funds?
There are lots of good reasons to have sinking funds, yes more than one. Here are just a few:
Make Big Expenses Easier
Putting aside a little bit of money every week or month to save up for a considerable expense you know is coming will make that expense far easier to shell out the cost for when the time comes. Most of us would rather have money for a significant expense already set and not come out of our monthly budget.
Or many of us will feel the need to play “catch up” for a few months after a big expense. Working sinking funds into our monthly budget makes the expected or unexpected significant expenses that much easier to handle.
Avoid Paying Interest
As we all know, paying interest does nothing but hurt you in the long and short term, even with low-interest rates. Having to borrow and repay money for a loan is extra money out of your pocket you can never get back. Paying interest on loans or credit card bills every month can be costly.
Instead of taking out a loan or putting a significant expense on your credit card and paying it off with interest, having a sinking fund for it will allow you to reduce the amount of interest you pay and hopefully make it no interest paid at all.
You Won’t Be Tempted To Use Your Emergency Fund
Sometimes with big expenses, we are tempted to use our emergency funds. Why not, right? It’s a lot of money just sitting there, not being used. However, it’s called an emergency fund for a reason. It should only be touched in case of income loss or a totally unpayable expense.
Using a sinking fund will help reduce our temptation to use those precious emergency funds as we’ll already have part or all of the cost covered.
Other Benefits of Having Sinking Funds
Besides the reason above, there are many other benefits to having sinking funds.
They Can Be for Anything
Sinking funds are not limited by any means to just everyday or inevitable expenses. You can create one for really anything you want. This might be for necessities, something fun, or something you simply want to improve your life. Expenses such as these are all fair game:
- Vacations
- Weddings
- Home Down-Payment
- Home Refinance
- Home Remodeling
- Car Purchase
- Medical Bills
- Holiday Gifts
- Date Nights
- Clothes
If you want to save for it, a sinking fund will work for it.
No Guilt Spending
With the previous paragraph in mind, a sinking fund allows us to have less guilt when spending money on something that isn’t 100% a necessity. If you saved the money, had it as part of your budget, and still stayed on target for other financial goals, then you have some guilt-free spending to do.
Less Stress
For those more considerable expenses that we know are coming, it can be far less stressful to put aside a little bit at a time rather than pay the bill all at once. Creating a sinking fund for these significant expenses will allow you to feel more comfortable that you’ll be able to afford the expense when the time comes.
Sinking Fund vs. Savings Account
So you might be wondering what the difference between a sinking fund and your run-of-the-mill savings account is. In all reality, the only difference is that your sinking fund simply has a specific purpose. In contrast, your savings account is simply for saving in general.
So, in fact, your sinking fund can be just separate savings account you’ve opened for yourself with the idea that it’s for a specific purpose.
Sinking Fund vs. Emergency Fund
Many people also think a sinking fund sounds a lot like an emergency fund. However, there are a few differences. For one, a sinking fund is created with the thought of eventually spending the money, whereas an emergency fund is hopefully never touched unless absolutely necessary.
Like a savings account, the emergency fund has no specific spending purpose either; it’s there to help you in case of income loss. Finally, the emergency fund could also be for expenses you did not know were coming, while the sinking fund is for expected costs.
How To Create a Sinking Fund
When you are looking to start a new sinking fund, there are several factors to consider. These include but are not limited to:
What Are You Saving For?
What Kind Of Account Will You Use
How Much You Need To Save
When Will You Start Saving
Can You Work it Into Your Current Budget
Let’s go over each of these in more detail.
What Are You Saving For?
When creating a sinking fund, the first question you need to answer is what exactly you are saving for. This is really quite important. This is setting the goal for the money\account, so it should be specific.
Saying, “I’m saving for a vacation,” is rather vague and can have a wide range of expenses. There more specific you are with your goal and reason for the sinking fund, the better off you’ll be.
What Kind of Account Should You Use?
You should definitely have a separate account for any sinking fund you wish to have; this is for several reasons. One, it will make it much easier to track exactly how much money you have for the specific goal of the fund. Two, it will make it harder for you to withdraw money out of it either by accident or on purpose.
Ideally, you should have the money in any form of a High Yield Savings account. This will make sure the money not only is set aside but will grow as well while you are saving up for your goal. If your sinking fund is long-term, consider investing it, but remember that runs the risk of your account losing value as well.
How Much Do You Need To Save?
When creating a sinking fund, you need a specific goal in mind so that you can have a specific dollar amount. Knowing exactly how much you need will help you figure out monthly saving amounts and\or the length of time you need to save.
You don’t need to be down to the penny, but you should have a very good idea of the amount of money you will need before setting up any fund.
When Should I Start Saving?
The easiest way to answer this is by saying as soon as possible. Of course, there can be more to it than that. On a high level, the soon you start saving, either the less you’ll need to put aside each month or the more you’ll have to spend when the time comes, or both! It’s really just a matter of how much savings you can fit into your budget.
For example, if you already have other sinking funds you are contributing to, maybe you just don’t have the means to have a third or fourth right now. Then, when the expense for the others comes up, and you no longer have to save for that goal, you can repurpose the existing sinking fund for your new purpose.
Does It Fit Into Your Current Budget?
To piggyback off the last paragraph, it’s important to not stretch your budget too thin, even for saving. Even with the best of intentions, if you suddenly have four, five, or six sinking funds, your budget might not be able to handle it.
Obviously, if you are saving for necessities, go right ahead, but the fun stuff might need to wait until you have some more wiggle room to fit the saving in.
Budgeting your income is still rule number one. If you can fit another sinking fund into it, great. If not, you should wait. Remember, though, this is all for your own gain.
You make the rules, and there is no minimum amount when it comes to saving, so even if you only put $10 a month into a sinking fund, it could help.
How Much Should I Save in a Sinking Fund?
Budgeting for a sinking fund depends on a few factors. These factors can change how much or how long you save into a sinking fund to reach your goals. It would be great to know what significant expenses were coming years in advance, but most of us don’t.
The two major factors determining how much you save each month are how much your final goal is to save and how long you have to save for it. Let’s say you have an expense of $1,000 coming up in 10 months. That means you’ll need to save $100 each month.
Let’s change that to $1,000, but you know the expense is only five months away. Now you’d need to save more and contribute $200 a month towards your sinking fund.
Another factor that can come into play is how much of the expense you want to be saved up. Maybe you don’t need to pay off the total amount, but you want to lessen the blow when the time comes.
Going back to our $1,000 expense, perhaps you can afford $300 of that each month no matter what, so you only need to have a sinking fund of $700.
Using the 10-month example, now, instead of $100 a month, you’ll only need to contribute $70 to reach your goal.
When doing your sinking funds, it’s all up to you, but always remember to keep specific goals in mind to help you along the way.
Related: Future Budget Planning – Rising Expenses Ahead
How Many Sinking Funds Should Have?
There is always such a thing as “too much of a good thing,” although it would be great to have a sinking fund for any and all expenses you know are coming up; there is only so much money in your paycheck. Don’t go opening ten or twenty savings accounts either, as you’ll drive yourself mad.
As mentioned before, the most significant factor is how much money you can contribute to sinking funds that still fit into your budget after paying your necessary monthly expenses.
Remember, the more sinking funds you have, the less you can contribute to each.
Before having too many sinking funds, you should also have your financial pillars in order. Meaning you should have little to no debt (excluding a mortgage, of course); your emergency fund should be fully funded or, at the very least well on its way to be.
You should have an established budget so you know how much you are capable of saving as well.
Once you have the pillars set, find the top two or three expenses you know are coming and see if you can work them into your budget. Obviously, the sooner you start saving for them, the easier they will be, as you can save less each month.
Another strategy might be to put all your savings into one sinking fund until it’s fully funded. Then move on to the next until that one is fully funded, and so on.
Final Thoughts
Sinking funds are a great way to get ahead of the game by saving for the future and making significant expenses less stressful. By setting up separate accounts for your sinking funds, you can easily keep track of exactly how much you have saved up and make it harder to take any money out. Have the funds in HYSA to add a bonus.
There are countless ways to save and manage your sinking funds, and it’s all up to you how you want it done, but the benefits are universal. Make sure you have your personal-finance pillars in order first before stretching yourself too thin as well.
