What Is A Sinking Fund?
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Summary:
Sinking funds are a budgeting strategy that allows you to cover expected expenses by setting aside small amounts of money over an extended period of time. Each fund is geared towards financing a specific goal or expense, such as car repairs or a future vacation.
Though a “sinking fund” may sound like a bad thing, it’s actually a helpful budgeting strategy that some consider a basic tenet of modern personal finance. A sinking fund is a fund you create to save money toward specific goals that you wouldn’t be able to cover with your monthly budget.
If you struggle to cover planned expenses or manage long-term debt, this could be the strategy for you. Keep reading to learn more about what a sinking fund is, how to create one, and why the technique is considered such a smart money management tool.
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What is a sinking fund?
Sinking funds are special savings accounts that are meant to help you save toward a variety of different expected expenses. You don’t have to set aside a large amount of money for it to work. In most cases, people contribute small amounts of their earnings, so that the funds are built up little by little.
It’s hard to tell where the term came from, as the first sinking fund was used over 300 years ago. Most believe it’s called a sinking fund because it prevents you from sinking further into debt. However, some anecdotes also suggest that it’s named a sinking fund because you “sink money into it.”
Do you need to have a sinking fund if you already have an emergency fund?
Yes, sinking funds do not take the place of an emergency fund. Your emergency fund is the one account that you should not touch under any normal circumstances. Sinking funds are there for planned expenses to reduce your chances of going into debt. In an extreme situation, your emergency fund is the safety net to prevent you from becoming homeless.
How do you create a sinking fund?
There are several ways to create a sinking fund. Some swear by cash sinking funds, such as the envelope system, which prevent you from overspending by using a credit or debit card. Others keep electronic records of their spending and saving to keep track of their goals. However, most people choose to have separate savings accounts for each sinking fund.
Regardless of your method, follow these steps to create your own sinking fund:
- Create a separate fund and label it for a specific purpose. Some people will open up separate savings accounts for this purpose, but it’s not required. Budgeting apps can also do this and some savings accounts also allow for subcategories. In the case of automated budgeting apps, you might be able to add different sinking fund categories as a feature of the app.
- Set aside a specific amount of money for the fund on a regular basis. In most cases, you can automate savings deductions as income comes in. There are several different services that can help you save money this way, so choose one that makes it easy.
- Make sure to budget for the savings. Depending on how many different sinking funds you have, the deductions can easily make a serious dent in your monthly budget. First make sure to calculate a budget for your funds to ensure that you’re not overstretching yourself.
What are the benefits of sinking funds?
Sinking funds are excellent for a number of different reasons. The most important things to keep in mind include these perks below:
- Monthly fees or unavoidable expenses. You will have money set aside for unavoidable expenses that you know are coming up. We often forget that monthly expenses aren’t the only expenses we have. Other expenses like car repairs or self-employment taxes are unavoidable. If you don’t plan, you might end up with a less desirable outcome.
- Large purchases. You can save for large purchases that you’ve been wanting to get. A vacation to Paris is a lot easier to afford when you use a sinking fund for it. Setting aside small amounts of money week after week can make almost all one-time expenses easier.
- No more buyer’s remorse. A lot of people who focus on their personal finances feel bad when they buy themselves something nice. By saving up for a specific purchase, you can splurge with a clean conscience.
- Structured savings. By budgeting for a known expense with a sinking fund, you can look at your finances and have a timeframe for any planned expense you have. You’ll know when you can afford home repairs when you can get that pretty handbag, and more.
- Expected expenses. We all know that life will occasionally throw us a curveball. Some of those expenses can be more predictable than others. For example, it’s safe to say you may need to have a fund for future car repairs and home repairs. But accidents happen, and it’s best to have a fund you can pull money from when they do.
- Not restricted by income or age. You don’t have to have a specific income or age to use sinking funds. Even kids can have sinking funds for their own allowances.
- Multiple sinking funds. You can also create as many sinking funds as you want. So, if you have any type of savings goal you want to reach, you can make it happen. You can do this by setting up a separate savings account for each sinking fund, keeping track of your funds in an Excel spreadsheet, or removing cash to keep in a separate envelope.
What kind of expenses are good financial goals for these funds?
A good goal is to save for any type of upcoming expense that can’t be covered in your regular monthly budget. In other words, if you worry that you may have to take out a loan for an expense, it can be avoided through the use of sinking funds. Some of the most common uses include:
- House down payments. Maybe you’ve had your eye on one house in particular or on a neighborhood with the perfect school district. Either way, a sinking fund can help homeownership become a possible dream.
- Expected repairs. Whether your home has a leaky pipe or your car has been making that weird noise, you should expect to pay for repairs at some point in your life. Despite the help car insurance provides, you still might not have enough to cover accident repairs. With an ongoing sinking fund, unexpected expenses can be more affordable.
- Taxes. If you are self-employed, you should definitely consider getting a fund started to cover your taxes. We all need to save cash for the IRS.
- Luxury purchases. Most of us have that dream vacation we want to go on, but can’t quite afford it by paying out of pocket. Or maybe you’ve had your eye on a new gaming system is about to come out. Regardless of the purchase, putting aside little by little can make these dreams a reality.
- Christmas gifts. This is an annual expense people often forget. A sinking fund helps make these annual purchases more affordable.
With this being said, there’s only so much planning you can do. If you need help financing an emergency expense or cover the remainder of a planned expense, a personal loan may be a helpful tool.
Pro Tip
A good way to figure out what you should save toward is to list all the expenses you expect to incur in the next three years. Once you do that, create a sinking fund for every purchase over $500.
Do you need a savings account to make a sinking fund?
Technically, you do not need to have a savings account in order to make a sinking fund. If you really wanted to, you can use a separate checking account, or even a series of envelopes as a place to park your money.
However, most people prefer to use a savings account. This is a good way to ensure that your money stays safe and that you don’t accidentally use that cash for your rent check. Besides, savings accounts can also give you marginal interest that can help you reach your goal even faster.
FAQs
How much should your sinking fund be?
The total value of your sinking fund should be equal to the price of what you’re saving for. If you are unsure of what your fund’s savings should be, assume that it’s going to be a major expense associated with extra fees.
So, if you’re saving for car repairs, check out the most expensive repair costs, then multiply that by two.
Is cash in a sinking fund considered cash?
The idea behind a sinking fund is that you can use that money immediately if you need to use it. In that way, it should be considered cash.
However, you can also have a sinking fund in bonds. In this case, the borrowers can repay the bond through multiple small payments rather than one lump sum.
What is the difference between sinking and emergency funds?
The difference between a sinking fund vs. an emergency fund is all in the purpose. A sinking fund has a specific set of savings goals in mind. An emergency fund isn’t earmarked for a specific goal or item that you’re saving for.
Moreover, your emergency fund should be your last resort for serious issues. For example, if you lost your job and got hit by a car, the fund should be there for emergency housing and medical expenses. A sinking fund is for specific items, rather than a moment where life turns upside-down.
What is the difference between a sinking and purchase fund?
A purchase fund is primarily a stock market term. This is a fund that is set aside to buy securities when they sink below the original market rate.
A sinking fund (for publicly traded companies or government entities) is used to pay off debts or to help avoid future debt.
Is a sinking fund taxable?
It doesn’t carry special taxes. In most cases, a sinking fund is not a managed account that features higher interest rates or any sort of capital gains. As a result, the IRS treats it the same as any other money you have in a savings account or checking account.
Key takeaways
- Sinking funds are savings funds that are meant for saving money toward specific recurring bills that cannot be covered in a single month’s budget.
- You can use these to build a down payment for a car, a house, or for medical expenses that you know you will incur.
- It’s still recommended to have an emergency account even if you have sinking funds.
- The objective of a sinking fund is to help you avoid debt or financial duress while you achieve your financial goals.
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