Sinking Fund: What it is and Why You Need One

When it comes to personal finance, you may have heard about the importance of having an emergency fund. But have you ever heard of a sinking fund?

Having an emergency fund in place will help cover unexpected costs. For example, maybe you’ll  lose your job, need a car repair or face a significant medical bill. That’s what an emergency fund is for.

A sinking fund is designed specifically for those expenses you know are coming, like summer camp for your kids, annual home insurance premiums and Christmas gifts.

By setting aside money before you need it, you’ll avoid having to use your emergency fund unnecessarily. You’ll also create a safety net to keep your financial goals on track.

What is a Sinking Fund?

A sinking fund is a way to save for planned expenses that aren’t in your regular budget because they don’t come along very often.

You keep the sinking fund in an account that’s separate from your emergency fund and your checking account.

Having an account where you can deposit a little cash each month for planned expenses will help keep your budget on track so you’re not tempted to dip into your emergency fund or use your credit card.

Plus, it builds a buffer into your budget and helps you set money aside for a specific goal.

Why Do I Need a Sinking Fund?

There are a lot of reasons that make setting up a sinking fund a good idea. Not only is it one of the best ways to keep you out of debt, but it also protects your emergency fund.

If you have an upcoming planned event, like a vacation, home remodel project, preschool tuition or property taxes, a sinking fund can help you save for it.

Even if you don’t know exactly how much the expense will cost, starting to save now will help you cover at least part of the cost instead of leaving your bank account depleted.

With a sinking fund, you can do a number of things that will keep your finances healthy.

Plan for Yearly Expenses

You might not know precisely how much money you’ll need for an expense, but setting aside a little each month can make paying for things like new car tires, annual vehicle registration and insurance fees less stressful.

Save for Anything and Everything

Whether you’re saving up for your dream trip to Paris, that road bike your husband has had his eye on, or a home remodel, a sinking fund can help you pay for everything you need or might want.

Spend Your Money Guilt-Free

By telling your money what to do, month after month, you’ll know how much money you have available as you work toward your financial goals. When it’s time to spend the money, you can do it without worry because you’ve budgeted and saved for it.

How Do Sinking Funds Work?

Sinking funds are different from a generic savings account, which is primarily used to build wealth. A sinking fund is money you set aside and designated for a specific purpose.

For instance, let’s say you save $600 every month and put this money into a single account. After a year, your savings climb to $7,200, and you decide to use the money to upgrade the siding on your home to vinyl siding.

Since you paid cash and didn’t accumulate any debt, you’re feeling pretty good about this home improvement project.

But what happens if you’ve got multiple goals? Maybe you’re dreaming of buying a better car, adding a deck to the house or finally taking that dream vacation you can’t stop thinking about?

With some planning, you could instead use that same sinking to pursue all of them.

You can divide your monthly $600 savings into separate categories to save for different purposes.

It might look like this:

• Home improvement: $300
• New car: $100
• Car repairs: $50
• Vacation: $150

After a year of funding your separate sinking funds:

• Home improvement: $3,600
• New car: $1,200
• Car repairs: $600
• Vacation: $1,800

Using a sinking fund, you’ll be able to save toward specific goals and can base your financial decisions on the money you have available.

Since you don’t have quite enough to pay someone to replace the siding, you can look at doing it yourself to save some money or wait until next year when you’ll have enough to hire someone to do it.

The best part? You can still take that vacation you wanted and be ready for home and car expenses that come up. All thanks to setting up a sinking fund.

Do I Need More than One Sinking Fund?

Since it’s such a great way to plan for large purchases and overlooked expenses, having more than one sinking fund can help you prepare for multiple goals.

A few you might consider are:

• A vehicle fund that can pay for license and registration fees, repairs, parking or speeding tickets, and new tires. You can also save for a new car with a sinking fund and avoid having to make a car payment.
• A home remodelling fund for the deck you’ve wanted to add in the backyard or to upgrade the windows in your house.
• A computer fund is helpful, especially if you rely on a computer for schoolwork or business. When your computer crashes, you’ll have the money to pay someone to fix it or buy a new one.
• A gift fund to save for birthdays, anniversaries and Christmas. Plus, having extra money for those unexpected baby showers, retirement parties and weddings will come in handy, too.
• A pet fund for your favorite furry friend’s yearly physical exam and vaccines, new toys to keep them entertained, and kennel or boarding fees when you travel.
• A children’s fund for school projects, field trips, piano lessons or an extracurricular activity like football or volleyball. If your daycare expenses are higher in the summer while your kids are home from school, you can use a sinking fund to even out those costs.
• A vacation fund for family trips to Disney World, the Grand Canyon or for that Caribbean cruise you’ve always wanted to go on.

Setting up and funneling money into sinking funds will safeguard the money you’ve worked so hard to get. You don’t need a lot of cash to set one up.

You can start by taking $10 or $20 from each paycheck to put into each of these sinking funds. After all, some money is better than no money, right?

Where Should I Keep My Sinking Funds?

Your sinking funds should be kept in reasonably liquid accounts, meaning you need to keep them in a place that’s easily accessible.

A sinking fund isn’t intended to increase your overall net worth, but rather to provide money to do the things you want or need to do.

When considering where to keep your cash, setting up a savings account is a simple solution. But a checking account or money-market account that comes with a debit card or check-writing option is a better choice.

Since you can get to it quickly, you can pay the plumber or mechanic without any trouble.

Whether you keep your sinking funds separate or combine them into a single account is a personal choice.

Having your money in different accounts is a little more work upfront, but it makes it easier to keep track of when you’re spending.

You could combine your sinking funds into a single account as long as you monitor how much money you’ve allocated to each category.

For many people, that gets confusing, so it’s often easier to keep your funds in individual accounts.

When Should I Use My Sinking Fund?

A sinking fund rests somewhere between a regular savings account and an emergency fund. It’s meant to pay for planned expenses that come up at unexpected times. That keeps the money in your emergency fund available for unexpected expenses.

After adding money to a sinking fund, you can use it at any time as long as you’re using it for the intended purpose.

For example, if you’ve set up a vacation fund and you’re ready to buy airfare or reserve a hotel room, now’s the time to use that money.

Another example is if you need new brake pads or a fresh set of tires on your car, you can use your vehicle fund to cover those purchases.

How Do I Start a Sinking Fund?

Starting a sinking fund is a straightforward process and begins with knowing how much money you have left after paying your necessary expenses. Here’s how to get started:

1. Create a Budget

If you aren’t already living on a budget, now is the time to do it. Listing your income and expenses will tell you the amount of money that’s available to use for your sinking funds. Knowing what’s left will also help you determine what funds to start and how much you can afford to put in each one.

2. Determine What Purchases to Fund

Make a list of your financial goals, and estimate how much money you’ll need for each one. For example, taking your family on a beach vacation could cost around $1,500. You may also want to work toward saving $7,000 to pay for a new roof on your home. By writing these down, you can prioritize what’s most important and set monthly savings amounts for each one.

3. Calculate How Much to Set Aside Every Week

Start by counting the number of weeks between now and when you think you’ll need the cash. Then, divide the amount you want to save by the number of weeks left until the event gets here.

For example, if you’re going to take your $1,500 beach vacation in five months, that is 20 weeks from now. If you divide $1,500 by 20 weeks, that gives you a target of putting $75 each week into your vacation fund.

4. Decide Where to Keep Your Money

Using your current bank might be the easiest option, but you can also choose to open your sinking funds at a different bank to keep the temptation to spend them at a minimum.

5. Make a Plan to Fund Your Accounts

This is the last step. Setting up automatic transfers through your bank or using direct deposit with your employer takes all the guesswork out of this process.

If you prefer to do it yourself, you could call or log into your bank to initiate a transfer every week. But definitely consider automating the process to make adding money to your sinking funds a painless process.

As you work toward each of your goals, you’ll feel motivated and empowered to see the money in each account grow. You may find other ways to save and put even more cash into each fund to hit your goals faster.

Summary

When it comes to personal finances, emergency funds are a great way to prepare for unexpected costs. But to better manage your money and stick to your financial goals, you need a sinking fund.

Having one will prepare you financially for expenses that don’t come up very often, like a yearly vacation, preschool tuition, new car tires and taxes.

Putting aside some money each month is an easy way to make room in your budget for large purchases, overlooked expenses and planned costs you know are coming.

Instead of draining your bank account or relying on your credit card, you can have the money you need when you need it by setting up a sinking fund.