When it comes to creating a budget, you can guess that preparing for an emergency situation is a key part of the process.
But did you know there are different ways to go about planning ahead for specific expenses?
Many people establish an emergency savings fund that is dedicated to paying for unexpected expenses like a hospital bill or a car repair, or covering for daily expenses if you lose your job.
However, life often brings other major expenses. You may need new appliances or a new car or another expense that is not part of your daily or monthly budget.
The way to budget for these one-time major expenses is through what is called a sinking fund. When you can anticipate a large cost, you can better prepare for it in this way.
Read also:
- Is $1,000 Enough for an Emergency Fund?
- How to Increase Your Credit Score
- Get Out of Debt Quickly with These Simple Steps
What is sinking fund?
Basically, a sinking fund is a special part of your budget in which you set aside money slowly to pay for larger expenses. Sort of like a personal layaway that you setup for yourself with your personal wish list.
The purpose of a sinking fund is to help you stay on track toward reaching your short-term buying goals. A sinking fund can cover any short-term expense, but they are designed to pay for things beyond just daily costs like food or gas.
You can set up another part of your budget to help keep you on track for paying for necessities.
A sinking fund works by creating a schedule for savings toward specific buying goals. It’s not complicated.
In fact, you may have even had a sinking fund when you were a kid. Did you ever have a dream to buy something that you could not quite afford? If you’ve had a vision for making a purchase and steadily saved up to make your dream come true, then you’ve had a sinking fund.
What are the benefits of a sinking fund?
You might be thinking that a sinking fund is just another financial hassle. It might be much easier to just pay for what you need in other ways. Afterall, it doesn’t actually make money for you.
But consider these points. First of all, starting a sinking fund requires barely any effort. As you’ll see below, it’s not complex. You simply need to designate how much of your money goes where – which is what you’d want to do anyway to achieve your financial goals.
Secondly, without a sinking fund, you might turn to other ways of paying for something that might actually hurt you financially.
For example, if you didn’t have a sinking fund for a new car, you would probably turn to a car loan. This car loan surely would come with interest, which can add up to an expense on it’s own. Another danger with using loans is the risk of default.
If you, for some reason, don’t pay the loan, this will negatively affect your credit score and you’ll have more trouble getting other loans, like mortgages, personal loans or credit card in the future.
Consider if you had a sinking account for your new car. You would steadily save up money over time, just as you would make payments on a loan, and then pay for that car in cash instead.
You will save tremendously on the interest connected to the loan, and you can be confident that the car is completely yours, with no risk of default on a loan from the bank.
Your other options for funding one-time purchases including using your credit card, which has the same consequences, but with even higher interest. Or, you could use your emergency savings, which would put you in a dangerous financial position if you did in fact face an emergency expense.
Now hopefully you can see how a sinking fund can really work in your favor. Many people find it’s worth the small amount of effort it takes to create one.
Is a sinking fund just the same as an emergency fund?
A sinking fund resembles an emergency fund, but it’s not the same. An emergency fund is intended to pay for expense that you don’t predict and can’t prevent. For example, if you lose your job, you’ll still need to pay for your living expense like your mortgage, rent, utilities or groceries.
With a sinking fund, you are saving with a plan to spend the money in a precise way. It’s for costs that you do expect.
Basically, with an emergency fund, you are trying to plan for the unknown. Whereas with a sinking fund, both your goals and amount you need to save are clear.
Having an emergency fund is critical to your finances. It keeps you out of destructive debt when unexpected events happen and you need to make major payments to keep your life going forward.
Without an emergency fund, you could easily slip into credit card debt or, worse, default on your bills.
An emergency fund is designed to keep you from slipping backwards with your financial health, while a sinking fund helps you move forward toward your goals.
You may have heard that you need a minimum of about 3 months’ worth of monthly expenses saved in an emergency fund to help keep you on track. Both emergency funds and sinking funds are important.
What a sinking fund does that’s important is to help you meet your lifestyle expenses without hurting your budget.
So, you can pay for, say, a costly vacation without putting it on your credit card and going deeper into debt as interest expenses add up.
Read also:
- Designing Your Portfolio: How to Allocate Your Assets by Age
- How Much Do You Need for an Emergency Fund?
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What are examples of sinking funds?
In your personal life, you can start a sinking fund for just about anything. Common sinking funds include ones that help you save for major home expenses like new furniture, appliances or major renovations and upgrades.
Many people also start sinking funds to save for annual expenses like Christmas shopping, insurance premiums or paying a tax bill. You can start a sinking fund for paying for a wedding or a luxury vacation, or other costly events.
Why is it called a sinking fund?
There’s nothing about a sinking fund that will “sink” you finances. In fact, the opposite is true. Sinking funds will help keep you afloat!
The origins of the term “sinking fund” are a little unclear. It could be that the name is a nod to the fact that you are “sinking” money into an account regularly. Or that this fund could keep you from “sinking” under debt. These are just guesses!
No matter your thoughts on how the term came about, one thing is sure – it should not be considered a negative strategy. A sinking fund is a positive financial strategy that can help you avoid stress and achieve your goals in a thoughtful way.
Read also:
How to Calculate Your Liquid Net Worth
How to Start a Sinking Fund
The first step for any method of making a sinking fund is to review your finances and goals. You need to determine a few things first.
After you have a solid understanding of your personal numbers, you can create sinking funds in a number of ways. You can have one in a matter of minutes.
Some people like to use what’s called the “envelope method.” With the envelope saving strategy, you use physical envelopes and label them with your buying goals. For example, you might have one envelope called “Christmas Shopping” and another called “Hawaii Vacation.”
Then, you put cash into each envelope according to your schedule.
You can also simply contribute to an official savings account. This method gives you the added security of having your funds insured by the FDIC, which insures bank accounts up to $250,000.
Using a Savings Account for Sinking Funds
If you are depositing your sinking fund money into a savings account, just be sure that you don’t use the funds for any other purpose other than what you’ve assigned to it.
Otherwise, that defeats the purpose of this sinking fund strategy.
In fact, you may want to keep your general sinking fund money in a separate savings account than your general savings account. Some banks do allow you to open multiple savings accounts with different names for the accounts.
This way, you will stay organized with what funds will be used for planned expenses, and what funds are dedicated to overall long-term savings goals. Make sure your account provides easy access to your cash so you can use it when you need it.
Also, if you are using a savings account for your sinking fund money, you may want to opt out of overdraft protection. This way, you will not be tempted to use the money for anything other than what you planned on using it for.
Finally, using a savings account offers a great advantage.
You can set up a regular automatic deposit from your checking account to your savings account. So you can just set up your sinking fund, and then not worry about making money transfers.
How Many Sinking Funds do You Need?
The number of sinking funds that’s ideal for you really depends on your own goals and your own budget, including your income, expenses and debt.
The more money you have in your budget dedicated to saving, the more sinking funds you can create. Of course, that doesn’t mean you should create dozens of savings accounts dedicated to your one-time expenses.
If you have multiple spending goals, you might consider starting an individual sinking fund for each one. Then, you could contribute to them simultaneously instead of saving for one expense, followed by another.
Putting small amounts toward multiple planned one-time expenses may work best, even if you save for each expense more slowly. That’s because you will keep all your goals on track. If you dedicate all of your savings toward one goal, say a new appliance, then your other goals will be delayed.
That’s why is good to set out a rough timeline in advance for when you want to spend the money in your sinking fund.
Sinking Fund Bonds
In the corporate world, companies create sinking funds to help them prepare to payoff debt, or the bond principals they will owe investors.
When companies have sinking funds to buy back the bonds, or pay the principal amount of the bonds, it will not have to pay as much once the bond is due.
As a result, investors feel more confident that the company won’t default and that their investment is more secure. So, more investors might be attracted to companies that have sinking funds to pay for their debt.
Having a sinking fund may also bring a better credit rating for a company because it will be considered more secure and credit worthy. Again, this can attract more buyers for the company’s bonds, increasing demand and benefiting the company if it needs to raise capital through bonds in the future.
The Bottom Line
When you use money that you’ve saved carefully with sinking funds, you can enjoy spending it with no guilt.
Paying for expensive items can be challenging, but this easy planning method can help you get what you want more easily — without pushing you into debt.
You can be confident that your finances will remain on track toward your bigger goals, despite the major expense you planned for. Your budget can remain on track, even with larger-ticket spending items with just a little advanced planning.
Sinking funds can be used for any specific spending need you see in your near-term future, helping you stay in control of your money and your budget.
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