A sinking fund is an account used to set money aside for debt or expenses. Companies often issue large sums of debt that can lead to an unattainable payoff if profits aren’t managed responsibly.
Instead of a single payment, it’s possible to contribute smaller increments to the sinking fund over months and years instead of having to come up with the money all at once.
The same idea is easily applied to personal finances. Chances are you have big expenses coming up in six months, a year or even five years. How will you save toward those expenses without cutting into your emergency savings or taking on more debt?
How Does a Sinking Fund Compare To a Savings Account?
A savings account is usually considered a catchall account. It’s where you stash money for unexpected expenses. Experts recommend that you have three to six months of living expenses set aside in case of job loss and other unexpected life changes that impact your income.
What About Expected Expenses?
You’ve saved for emergencies, but you also have a long list of things you want. They don’t warrant chipping away at your traditional savings account, but they don’t fit in your monthly budget.
That’s where a sinking fund comes in. It’s like a savings account but with a very specific purpose and goal. That wish list of ideas you’re juggling in your head? Set up a sinking fund for each one! Examples include:
|Braces for your child||$2,500|
|Down payment on a new car||$5,000|
|Wedding shower for your husband’s sister||$500|
How Do I Prioritize?
When you look at a list of expenses this long, your goals can seem unattainable. You may even feel like giving up and taking out a loan or waiting to see if things just work out somehow.
Chances are, $15,000 isn’t just going to land in your lap anytime soon. By creating sinking funds for each of your specific goals, you can determine exactly how much you need to save each month.
If your sister-in-law’s wedding shower is in eight months, that may take priority over a down payment for a new car. If your child needs braces three years from now, you have more time to save. Setting aside $70 a month adds up quickly.
How Do I Establish A Sinking Fund?
- Set your goal. Be specific about what the account is for.
- Open an account. Make sure you don’t get charged fees or have a minimum balance to maintain for your sinking fund.
- Establish an amount. Make sure you know exactly how much your purchase costs are.
- Write down a timeline. Know when you want to achieve your goal and make sure you save enough each month.
- Add it to the budget. Make sure your sinking fund is explicitly outlined in your budget.
How Can I Incorporate Sinking Funds Into My Budget?
You should assess your budget every month and adjust for changes in your expenses. Maybe last month you had to renew the registration for your car, but this month you have a niece’s birthday to attend.
1. Create a Line Item
Add your sinking fund as a specific line item to your budget. Prioritize it along with bills, emergency savings and paying down debt. Spending money is fun, but it can also be stressful when it doesn’t fit into your budget.
By adding your dream vacation as a line to your budget, you can slowly chip away at the expense of plane tickets and a hotel room without adding debt to your credit card. Then when it comes time to pay for your trip, you can pay with a clear conscience that you’re doing so responsibly.
2. Don’t Be Flexible
The trick to making a sinking fund work is to not dip into it for other expenses. That defeats the purpose of saving toward a specific goal. If you break the rules once, it will be too easy to do it again in the future.
3. Seek Advice
If an unexpected expense comes up, consider using your emergency fund. After all, that’s what it’s there for. Keep in mind that dipping into your emergency savings may mean pausing contributions to your sinking fund as you replenish your savings.
If you’re married, talk to your spouse about how to pay for unexpected expenses. If you’re single, talk to a trusted friend or family member to get advice for what you should do.
4. Automate Transfers
Most banks allow you to set up automatic transfers on designated days. If you know when your paycheck deposits, schedule an automatic transfer to your sinking fund for the same day. You won’t even have a chance to miss the money.
Pros and Cons of a Sinking Fund
As with anything in life, there are good things and bad things about a sinking fund. Before committing to a sinking fund, it’s important to decide if it’s the right choice for you.
A Sinking Fund Benefits You in Many Ways
Avoid Paying Interest
The alternate to saving in advance for a large purchase is paying for it with debt. Whether you use a credit card or a personal loan, interest rates force you to pay more than if you used cash.
You may think that you can apply the money you’d contribute to a sinking fund to paying off a loan, but it’s not the same. You owe someone else instead of owning something free-and-clear. A sinking fund offers financial freedom from more debt.
Earn Money On Your Balance
With the right savings account, you can earn a yield on your balance. If you have a short-term goal, the yield may only be a few dollars, but every bit counts.
Control Your Money
Debt leaves you with a tight budget as you try to manage payments to all of the places you owe money. Some debt is inevitable. Each month you have to pay your utilities, phone bill and internet. You may always have a mortgage or rent payment. When your mortgage is paid off, you’ll still need to pay taxes and insurance.
But taking on unnecessary debt doesn’t have to be the norm. Most people have debt, so it seems socially acceptable. By opening a sinking fund and committing to saving toward large purchases, you’re changing the narrative. You’re telling your money that you’re in control of how you spend and save.
Avoid Impulse Purchases
When you get into the habit of saving for large purchases, you curb impulse spending. With lenders ready to approve you for credit cards and personal loans, even large purchases have the potential for impulse.
Once you commit to a loan, you may not be able to return your purchase and reverse the sale. But if you set up a sinking fund, you have months or years to think about exactly how you’ll spend your money and why.
A Sinking Fund Also Has Its Pitfalls
You’re Locked In
Well, not really. But if you commit to the sinking fund as it was intended, then you’re technically locked in. Once you begin contributing toward a purchase, you have to follow through and fulfill your commitment.
If at the end of the term, you decide that the purchase isn’t necessary, then you’ve created a nice nest egg for something else.
You Might Break the Rules
Since a sinking fund isn’t truly locked in with restrictions to access, it’s easy to break the rules. You may think that just this once, it’s okay to dip into your sinking fund for something you want.
It’s worth saying again: If you break the rules once, it’s too easy to do it again. The lines become hazy, and suddenly your sinking fund is just an alternate spending account.
Start with one sinking fund to test the waters. If it works for you, consider setting up additional sinking funds for other purchases you have coming up. If it doesn’t work for you, think of another strategy to save for large purchases.
Your Budget Is Tight
A sinking fund is a great idea in theory, but what if you don’t have room in your budget to save for a large purchase? It’s definitely possible to cut back in places, but all budgets have a limit.
If that’s the case, consider how you can pick up extra income. After all, no matter how much you put them off, the anticipated expenses aren’t going anywhere. You’ll have to address them whether you’re financially prepared or not.
You’re Not Disciplined
Maybe there’s room in your budget, but you’re too quick to swipe your card without thinking first. Maybe you outline a budget, but treat it more like a guideline. Sinking funds only work if you commit to the savings goal and set aside money regularly.