What Is a Sinking Fund? All Your Questions Answered
In personal finance, there is no shortage of terms and acronyms to know. A sinking fund is one of these terms. But what is a sinking fund? Why do you need one? And what is the best place to set one up? Keep reading to find out the answers to all your sinking fund questions.
What Is a Sinking Fund?
A sinking fund is a targeted saving strategy. Saving a specific amount of money for a particular purchase is a sinking fund. It helps you to set aside money for irregular or one-time future purchases. These purchases could be a new roof on your home or your next vacation, just as a few examples.
Although the term “sinking fund” can seem negative, it has a very positive meaning. It relates to the decrease in debt remaining as your expenses get paid off. I like to think of it as a way of preventing significant expenses from sinking your budget. That is if you think of your budget as a ship or boat.
What Are the Benefits of a Sinking Fund?
There are many benefits of creating sinking funds and having them as line items in your budget. They can prevent you from scrambling at the last minute to pay an expense, dipping into your savings or emergency fund, or using credit (or your high-interest credit card) to pay for things. Here are some other benefits of a sinking fund:
Peace of Mind
Knowing that you have money set aside for upcoming expenses can create peace of mind. You don’t have to worry about where the money will come from because you have already made a plan in advance.
Manageable Debt Load
Being aware that you won’t have to dip into savings or borrow more money for upcoming expenses is one way to manage your debt load. The money you allocate for debt repayment can stay there instead of having to be repurposed to something else.
Save For Anything (and Everything)
There are no rules or limits to what you can create a sinking fund for. Whatever you want to spend money on eventually can be prepared for with a sinking fund.
Knowing that you have created a plan and have saved money in advance will help you spend guilt-free when you make that specific purchase. You have a strategy for where the money will come from; no need to worry about that either.
Plan For the Unexpected
While some sinking funds can be for a specific purpose (5-year furnace repair fund, for example), you can also create more general accounts (home repairs). If you have more generalized funds set up, then when something unexpected happens, you will have the money to cover the expense without having to use credit or dip into your savings account or emergency fund.
The Power to Negotiate
Often when you are buying big-ticket items, there is some room to negotiate if you are willing to pay in cash. Because you have saved in advance, this may be a possibility for you compared to someone who will put it on their credit card or borrow to pay for the expense. Cash purchases have the power to save money.
Sinking Fund Calculation
Calculating how much money you need to save in your sinking fund is an easy 3 step process. And don’t worry, the math is relatively painless.
Determine what the expense is and how much it will cost.
Decide how long you have to save for the expense or when you will need the money.
Divide the total expense cost by the amount of time you have to save for it. (Divide the number from step 1 by the number in step 2).
Sinking Fund Example
Here’s an example to help clarify the easy math.
Let’s say that you want to go on a vacation next year. You estimate that the total cost of the family vacation will be $3000. And you plan to go on the trip in 12 months from now.
How much will you need to contribute to your sinking fund every month starting now to afford your vacation later?
Take $3000 and divide it by 12 months ($3000/12 = $250). You will need to put $250 a month away for 12 months to pay for your family vacation.
How to Set Up a Sinking Fund?
Now that you know how to calculate how much to save, let’s go over the next 2 easy steps you can take to set up your sinking fund.
First, you will want to create a line item in your budget for the amount you have calculated. Make sure that you can afford that amount in your budget. If not, you have a couple of options to decrease the required monthly amount.
Your first option is to look for a lower-cost item. From the example above, maybe you can find a family vacation for $2500, saving you $500.
And your second option is to lengthen the time needed to save for the item. Maybe you can take the family vacation above in 18 months instead of 12 months from now. Extending the time frame you have to save would mean only having to put aside $167 a month ($3000/18 = $167).
You could also apply both of these strategies to drastically decrease the amount you need to set aside every month. Need only to save $2500 but have 18 months to do so? You would only need to save $139 a month to afford your vacation ($2500/18 = $139).
Once you have created a line item in your budget, the final step to setting up a sinking fund is to start saving. I recommend setting up a separate account for these funds (more on that below) and then automate your savings. The more you can automate, the more likely you will be to stick to the plan.
Sinking Fund or Emergency Fund?
The quick answer is both.
A sound financial plan includes both an emergency fund and sinking funds. Although they may appear to be the same and have some similarities, they are very different.
Both funds help you be prepared financially and are safety nets of sorts.
But where they differ is that an emergency fund is for unplanned, unknown, and unpredictable expenses. You have no control over how much money will be needed to cover the emergency expense or when that expense will come up. How can you predict when you might chip a front tooth or how much out of pocket it will cost you to have it repaired?
The benefit of an emergency fund is that it makes the emergency feel like less of an inconvenience. By having money set aside for the unpredictable, should something come up, you will be able to afford it without going into debt.
A sinking fund, on the other hand, is planned, purposeful saving for known expenses. You know exactly what that money is for, how much it will cost, and when you will need the money (and therefore how much you will have to save every month).
There is no element of surprise with a sinking fund. Remember, it is a targeted saving strategy.
What’s the Difference between Sinking Funds and Savings Accounts?
Although both options relate to saving money, there are some differences in the specifics. A general savings account is for life plans, money goals and to help you build wealth. A long-term goal such as retirement may be the purpose for the funds in your savings account.
Because of the long-term nature of the funds, you may consider including them in your net worth calculation.
A sinking fund is a specific and intentional type of savings account. The money you accumulate in this type of account is spent in somewhat of a short term. Because this money will be spent soon, it is often not included in a net worth calculation.
A benefit of separating your sinking funds from your savings accounts is the psychology of saving.
If you are saving for something specific and have named that sinking fund in your budget (a vacation, for example), you are less likely to spend that money on something else.
But if you have all your savings lumped together in general savings accounts, it will be difficult to tell what dollar is for what, and you are more likely to spend your money on other things.
Sinking Fund Categories
There is no limit to what you can create a sinking fund for. It is your budget, so you can determine what is important to you. Here are 25 sinking fund categories you may consider adding to your budget:
- Christmas Gifts
- Non-Christmas Gifts
- Pet Costs (food, grooming, etc.)
- Vet Bills
- Vehicle Repairs
- Winter Tires
- New (To You) Vehicle
- Baby Shower
- Plane Tickets
- School Supplies
- Membership Renewals
- Kids’ Activities/Registration
- Tuition/School Fees
- Major Home Repairs (roof, furnace, appliances, etc.)
- New Furniture
- Taxes (if self-employed or you pay in installments)
- Annual expenses (property tax, insurance – home, car, life, etc.)
- Medical Costs
- Home Down Payment
- New Computer
Where Is the Best Place to Keep Sinking Funds?
There are a few different ways to keep your sinking funds, and which one you choose will depend on how you budget.
If you are using the cash envelope system to budget, then the best way to keep your sinking funds is to create separate envelopes for them. Withdraw the cash as you would for all your other budget categories, and then just keep accumulating the money in the specific envelope.
But if you are not a cash-only budgeter, then Moka may be an excellent option for your sinking funds. With Moka, you can automate your savings (highly recommended regardless of the method you choose), round up your purchases to put more into savings, set up individual savings goals, and even invest your savings if you want.
If you want to know more about Moka, here is a detailed review of everything you need to know before signing up.
And if using an app seems too high-tech for you, why not open a no-fee high-interest savings account? Canada has many options for this, and once you open the account, you can set up automatic transfers from your chequing account.
Regardless of where you choose to keep your sinking funds, using a visual tracker to keep track of your progress can be highly motivating. There are lots of free visual trackers available for download online.