Sinking Funds: Why You Need Them. How To Set Up Yours!

Sinking Funds

Here's the thing: There are many tools out there to help you save money. They teach you where to set up your savings, how to do it, and what to use them for. Study them all, and you'll probably have your finances in good order. But if you really want to be smart about your savings, you'll need sinking funds.

Especially if you want to know the best way to save money to cover all your expenses and actually enjoy the fruit of your labor, you'll need something better than a run-of-the-mill savings account.

In this article, we will discuss everything you need to know about sinking funds - the why, the what, and the how. You'll learn how to rethink your finances, save intelligently, and spend guilt-free for big events.

Ready to learn more? Let's dive in.

What are sinking funds?

You may be wondering what this is. Simply put, it is money that you save each month towards a one-time or irregular predetermined expense.

As one of the examples of sinking funds, say you're hosting a baby shower with dozens of guests 6 months from now. How will you pay for it?

Do you tap into your emergency fund? Do you cut down on the rest of your budget? Pay it off by credit card?

Believe it or not, there is a better way.

You see, with a sinking fund, you intentionally set aside money each month toward a big financial expense. In this instance, you'll set up a "baby shower sinking fund" and put in money towards it each month. By the time your event arrives, you're not scrambling to pay for everything because you're well prepared.

It's not just for parties and events, though! Another sinking fund example could be for something like preventative dental work. There's also car maintenance and others.

Why is it called a sinking fund?

Don't be fooled by the seemingly negative word "sinking." In more traditional circles, "sinking fund" refers to money set aside to pay off long-term debt such as a bond.

The term "sinking" likely refers to the decreasing level of debt remaining as it gets paid off. While it may not be the most user-friendly term, don't be put off by it.

Used correctly, a sinking fund may be the missing tool in your personal finance arsenal. It can help you to stay out of debt and enjoy spending money on meaningful experiences.

Why do I need a sinking fund?

Without a doubt, in the coming months, an expense will likely come up that is outside of your usual monthly budget. That in and of itself is not a bad thing.

A friend sends an invite to her birthday, your son needs supplies for his science project, or you decide to treat yourself to the spa. Life happens.

When you don't have any types of sinking fund accounts, you may be forced to make these purchases through another source of funds, i.e., your emergency fund, your savings account, or your credit card.

A sinking fund helps you to plan for large purchases. It also helps you stay on track with your savings goals, keeps your debt low, and allows you to make purchases freely without feeling the pinch.

The difference between a sinking fund and an emergency fund

You may still feel confused. If you already have your emergency fund stacked up, why would you need a sinking fund? Well, for starters, the main difference between the two forms of savings is when you would use them.

Emergency funds are reserved for just that - emergencies related to unexpected expenses. You have no idea when they present themselves, and you have no control over the amount of money they demand from you. If you suddenly fall ill and need to go into surgery, the circumstances are largely out of your control.

With sinking funds, on the other hand, you can anticipate the upcoming expense and plan towards it. There's no element of surprise and no changes to your other savings buckets.

The difference between a sinking fund and a savings account

So you understand the distinction between a sinking fund and an emergency fund. You may still be wondering why you couldn't just use your savings account for non-emergency expenses?

It's easily accessible; the money is rather idle. Surely it's a no-brainer to use your savings to cover some of your off-budget expenses, right?

Not so fast. While mechanically, there isn't much difference between using your savings account and your sinking fund, the difference is mainly in your desired outcome. With a sinking fund, you have a specific target you are looking to purchase, and so you save towards those expenses.

With a savings account, your focus is likely on saving for specific financial goals you want to accomplish or life experiences you want to have. A savings account is set up primarily to ensure you are putting money aside for these specific goals.

A sinking fund is not a savings account

Using the two interchangeably, while possible, is not advisable. A lot more discipline will be required to keep savings separate from the money you may want to use to fund your large purchase. All it takes is a few missteps, and you could find yourself in the red on savings.

Setting up a sinking fund separately is your best bet for managing your finances responsibly.

What is a sinking fund used for?

While there is no hard and fast rule on what this fund is for, there are some categories of expenses that would naturally fit the bill.

Allocating your sinking funds to these categories ensures that your savings account and emergency funds remain intact.

Examples of expenses to create sinking funds for

So, now let's get into the types of sinking funds you need to set up. Of course, you can customize your sinking funds categories to fit exactly what you need.

A sinking fund example would be something like an upcoming event or perhaps a large purchase. Below we cover the most common types of sinking fund you will need.

1. House

You can set up a dedicated fund specifically to save up for a house down payment.

If you're already a homeowner, you'll likely need to repair damage to your property at some point. Insurance does not cover everything, so having the extra layer of cushioning will go a long way.

While it's hard to predict exactly what kinds of repairs you may need to make in the future, one way to prepare is by considering the cost of some of the more valuable items to fix within your home.

Focus on items that you are sure your insurance company would not pay for. Which could be your security system or the heating system. Whatever it is, you'll also want to have an estimate of how much longer the current system can last before you need to replace it.

Once you have an estimate for this figure, convert the amount into a yearly figure, and the final amount can qualify as your sinking fund for your home.

2. Car 

Owning a vehicle comes with costs. Gas, insurance premiums, car payments - the monthly upkeep costs can feel intimidating. A sinking fund can truly be a game changer in controlling car expenses.

It can play two roles. Firstly, you can use it to fund the purchase of a new car. Secondly, you can use it for repairs.

If you're in the market for a car, setting up a sinking fund a few months in advance will help to offset costs significantly.

Say your budget is $8,000, and you are looking to purchase a vehicle 8 months from now; you can save $1,000 each month in your fund until you reach your $8,000 target to finance the purchase of the vehicle.

3. Furniture 

Any large furniture purchases such as a new couch or a new TV would benefit from the creation of a sinking fund. The beauty of furniture needs is that you can often anticipate them well in advance. If you'll be moving into a new home, you'll often think and prep for the move months ahead.

Or, if you notice that your couch needs replacing, you can often afford to wait a few months before doing so. During that window, you can focus on building your furniture sinking fund in order to avoid incurring debt for the purchase.

4. Self-employment tax

Another sinking fund example would be a fund you set up for your taxes. If you run your own profitable business, you can expect to owe money to the IRS in the form of self-employment tax.

Typically, if your income after expenses is over $400, you will be expected to pay both Social Security and Medicare taxes. And this applies to freelancers and independent contractors in addition to business owners.

5. Wedding

Whether you're the one getting married or you're attending a friend's wedding, you probably have more than one expense to think of. Your transportation, accommodation, gift, and not to forget, the cute dress you're hoping to wear.

Wedding expenses can quickly add up. Putting a sinking fund in place can help you celebrate with financial peace.

6. Christmas gifts

You almost can't get around them. Christmas gifts are a staple in most homes and can do some pretty significant damage to your pockets if not budgeted for.

Not only will a Christmas sinking fund help you prepare far in advance for purchasing gifts, but it will also help you to carefully think through how much you truly want to spend on gifts for your loved ones.

Intentional and meaningful spending on holiday gifts goes a long way over giving in to enticing holiday marketing from retailers, and your sinking fund can help you achieve that.

Use these examples of sinking funds to set up your own.

How much do I need to put in my sinking fund?

As you've seen, during one calendar year, you'll likely encounter large, one-time expenses. Some you'll know because they show up like clockwork every year, such as your Amazon Prime subscription, and others will arise unexpectedly, such as an invitation to a birthday party from an acquaintance.

Whatever the case, every person's circumstance is going to be different. However, the general principles for any types of sinking fund will be the same:

  1. List out your sinking funds categories and the amount you're looking to save in each.
  2. Decide how many months you want to save over.
  3. Divide the amount needed by the number of months.
  4. Transfer that amount into your sinking fund for the category.

So, for example, you have your wedding anniversary coming up in 10 months. You find a great vacation spot that will cost you $2,000. Divide $2,000 by 10, and your monthly contribution to your anniversary sinking fund will be $200 for the next 10 months.

Using a sinking fund calculator

A great way to help you figure out how much you need to save to achieve your savings goal is to use a sinking fund calculator!

You input the amount you want to save, the amount of time you want to save it by, and the interest rate you earn on your savings account.

Here are some of the best sinking fund calculators:

Good calculators

Good Calculators offers a comprehensive option asking questions about correct currency and compounding. It also gives you the math formula to find the information you need if you prefer.

Omni calculator

Omni Calculator can help you with sinking fund amounts, but they also have a ton of other great financial calculators to help you run the numbers.

MyMathTables calculator

MyMathTables offers the simplest sinking fund calculator if you just want a quick answer for how much you can save.

You don't need much information beyond the interest rate and the amount of time to get an answer, and it has the math formula available, also.

Calculate how much you need to save per week or month to reach your goal!

What is the right number of sinking funds?

The number is going to depend on your goals, time frame, income, and how much money you want to save. You may be able to save for several small goals at once.

Or, if you like to stay focused on one thing at a time, then prioritize your different sinking funds and save for them separately.

The exception for this would be if you know it's going to take you several years to save. In that case, you can save money in a larger sinking fund while simultaneously working on some smaller ones.

Where do I keep my sinking funds?

Before we discuss options for where you may want to keep your funds, we need to do some self-examination.

Honestly, how good are you with managing a savings account? Do you manage to keep your money in there long term, or are you constantly making transfers in and out of the bank account?

It's a no-fluff question. Being real about this response will help determine where you can house your sinking fund and get it to work for you.

If you're disciplined with your savings account

If this is you, you have it easy. You can simply create a separate savings account specifically for a sinking fund category and use it only for that. You'll be able to easily see all your money in one place using your regular bank.

If you're not so disciplined with your savings account

You could establish a money market account. While money market accounts are slightly less accessible than your checking and savings account, they offer higher interest rates and provide a layer of security should you be tempted to cash it before its time.

Another reinforcement could be to track your account using a system such as You Need a Budget or Mint to hold yourself accountable each month.

Building your sinking funds into your budget

Building your sinking funds into your budget should be an easy task. The beauty of these expenses is that you'll often know well in advance what they are and can comfortably budget for them.

You can look at your goal amount for your sinking fund and then break it down by month or week, saving a certain amount toward your goal each time.

Categories will be different for most people; however, there are a few staple items you may want to always include to avoid any surprises later down the road. These include car repairs, small home repairs, e.g., replacing light bulbs, and smaller medical expenses such as prescriptions and copay.

Sometimes it may appear as though there is an overlap between some emergency fund categories and sinking fund categories, such as medical expenses and home repairs. However, it is important to note that sinking funds for these categories can be used when you need to cover planned expenses.

True medical conditions and extensive home repairs that take you by surprise can fall under your emergency fund.

The bottom line when it comes to sinking funds: You need them!

Sinking funds are pretty easy, right? Absolutely!

Yes, you can buy that outfit. Yes, you can splurge on that gift box. And yes, you can go on that vacation of your dreams that you've been keeping an eye on.

But like anything worthwhile, it takes some work and dedication to get there. You have to plan, you have to act, and only then will you see results. What could be better than that?

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