Have you heard of sinking funds? My wife and I used sinking funds before we even knew what they were – and it was entirely by accident. This post explains sinking fund strategies for beginners and how you can use cash to take control of your finances.
Sinking Funds Keep You Afloat
With so many unknowns in life, you never know when a financial situation will occur that you’re completely unprepared for. For example, say you’re sitting at home, and your central air stops. Here in Arizona, that’s pretty much the worst thing that can happen in the summer.
This problem falls just short of calling 911 because there’s little to no chance you’ll be able to sleep through two nights, let alone one, without air conditioning.
To add to the stress, you have no idea how much it is going to cost to fix it. It could be a simple hundred dollar fix, or you could be facing the harsh reality of needing an entirely new unit.
Either way, you’re going to have to figure out a way to get it fixed and pay for the service. In the past, your only choice may have been to use a credit card. Which led to trying to pay off the repair for the next few years.
Even with a $2,000 emergency fund, this may not be enough to cover the expensive repair.
This is where a sinking fund offers help. In this article, we’re going to talk about everything you need to know when it comes to these types of funds:
- How to set them up
- How to calculate how much to put into them
- How to figure out how many you should have
What Is A Sinking Fund And What’s The Purpose?
Before deciding to actually set up one of these funds, it’s important to know their purpose. In simple terms, the sinking fund definition is:
a fund where a person sets back a certain amount of money over time in order to use it for future expenses.
Each sinking fund serves a unique purpose. They can be for something specific, like an event or future purchase, or they can be set up for any unexpected situations that might occur.
To avoid destroying your budget by unexpected financial disasters, it’s important to make a plan to protect yourself. The whole purpose of a sinking fund is to be able to have that extra money to help you in these instances.
Sinking funds are person-specific and while you and I may have similar funds, you may have different financial needs and additional funds.
How Do Sinking Funds Work?
It’s also important to understand how sinking funds work. Basically, you set aside money every month for a certain goal. I will detail how to make and calculate them later in this article, but understand it’s important to set goals and boundaries.
For starters, make sure you know what you’re saving for. While an emergency savings is for general emergencies, sinking funds work much better if you know exactly the specific purpose of the fund.
Sinking funds work hand in hand with your monthly budget. Think of them as a bill that you pay to yourself.
Since everyone has different earnings and situations, it’s important to look at your personal details and figure out what amount you can afford to delegate into each fund. You might be surprised at how much you can spare to put into these funds every month when you are intentional about it.
Sinking Fund – What’s With The Name?
Now that you know what a sinking fund is, you might be wondering why it has that name. Some people might think it’s called this because they feel like they’re sinking when unexpected expenses come up, but that’s actually not the case.
While the word sinking has a negative connotation, it actually has to do with sinking or decreasing, the amount of debt you owe or might owe in the future. If you use this type of fund correctly, it can really make life a lot easier. My wife and I have avoided our fair share of financial emergencies by using this method.
Not only will you have more financial freedom, but the impact of an unexpected financial situation won’t be as severe. With so many people struggling and living paycheck to paycheck, this is something that’s extremely important and crucial to living a fulfilling life.
Why Sinking Funds Are Important
Besides helping you learn how to save money, a sinking fund is important for a couple of different reasons. For starters, you never know what life will throw at you or what kind of situation might come up.
Building sinking funds is essential to being financially literate and responsible. If you’re looking to improve your financial situation, add sinking funds to your strategy.
Depending on the exact circumstances, these situations can make or break your budget and end up putting you behind on all your other bills. Another reason they’re so important is that they reduce the chance of you having to put yourself into more debt, by opening a credit card or taking out a loan.
When you’re already on a tight budget and barely scraping by, the last thing you want is to add is another bill or payment to your monthly expenses. This is especially true for those things that can take belongings as collateral.
How To Make A Sinking Fund – For Beginners
Think about your own life and the typical financial emergencies you experience. This can be anything from vehicle maintenance, air conditioning repairs, you name it. Keeping sinking funds separate from your regular money will help you create better financial habits.
These funds can also be used for planned expenses that usually go on a credit card (i.e. vacations)
Once you know what you want to save towards, decide how much you are willing and able to delegate into this fund or funds each month. Think of them as monthly bills that you have to pay.
For example, you might want to save $200 for a special occasion or $5,000 for a vacation. Next, decide how many months you need to have this total amount. By doing a few simple calculations, you can figure out how much you need to be putting away.
How Many Sinking Funds Should I Have?
For us, we have three main sinking funds:
- Vacation Fund
- Vehicle Fund
- Kids School Fund
- Emergency Fund (already funded)
- Fun Money Fund
The reason we don’t have an air conditioning fund or other high dollar funds is that we also have 6 months of emergency savings saved up in cash. However, when we were first starting out we had other smaller funds delegated to more specific issues.
We also send our kids to private schools so we put money away each month into that fund to help offset the tuition balance. This does not include their college fund.
This is where the personal in personal finance comes into play. You may not have the same funds that I do – and that’s OK!
Large And Planned Purchases/Expenses
To start, we have large and planned purchases. The targets in this category should be ones that you already know about and require a decent amount of money to purchase.
These can include things like a large vacation, some upcoming and needed work on your car, a down payment on a house or a new family vehicle. Since these purchases take so much money, they should have plenty of time associated in your timeline.
Small And Planned Purchases/Expenses
The next category is ones that are considered small and planned purchases. Similarly to the previous category, these should be targets that are already known about and planned for. The only difference is that they won’t cost nearly as much money.
Some examples of situations that could go into this category are:
- Small household appliances
- New flatware or dishes
- Upcoming special dates like anniversaries and small family day trips
These might not take nearly as long to earn towards and you might actually meet the amount in just a few paychecks. One thing to keep in mind is that you don’t want to dip into this fund if you come across something you like because it can throw off all of your earnings and really put a damper on your plan.
The third category you should put your targets is the unexpected expenses/purchases. While you might not necessarily know what this will be for, you’ll at least know that it’ll be used when something unexpected happens.
The more prepared you are, the higher the chance that the situation won’t financially devastate you. Some situations that would fall into this category are:
- Broken appliances
- Cars that need sudden repairs
- A new computer
- Surprise medical expenses
Since you never know when these things will happen, you should try and save as much money into them as you can. The main reason is that these situations usually aren’t very cheap, so saving as much as you can will help decrease the amount you’ll have to pay out of pocket.
No matter how prepared we think we are, there’s going to be a time when something completely slips our mind. If you don’t have three to six months of living expenses saved up, having smaller sinking funds is a great alternative.
Just like the unexpected category, you might not automatically know what situations will be taken care of with this category. Some situations you might run into are:
- Expenses that only happen every 6 months
- A school trip that happens later in the year
- New clothes for your children and various school activities
Many of these things we know about at one point, but end up completely forgetting about because they’re not things we think about on a daily basis.
How Are Sinking Funds Calculated?
Basically, there are 2 main ways to figure out how to do your calculations. The first way is by seeing how much you want to put into each target and how long you have to do it. You’ll then divide these numbers.
For example, if you have 18 months to save $3,000, you’ll want to divide 3000 by 18. This results in needing to save $167 every month. The other way is to look at the extra money you have in your budget and divide it up into your separate categories.
Keep in mind, the most important purchases should receive a higher portion of the money available.
How Much Do I Put in?
You’ll know how much you need to put in based on which calculation you did. If we take the example of $3,000 in 18 months, then you know you’ll need to put in $167 per month.
If you get paid 2 times a month, this equals around $83.50 out of each paycheck.
If you do this with each of your targets, you’ll be able to add them together to see the amount you’ll need to take out each month in order to add to your sinking fund total. If you use the other method, then break down the extra money you have and keep putting that amount in.
When one sinking fund reaches your goal total, this gives you the ability to add more to your other funds.
Examples/Types Of Sinking Funds
We’ve been talking about sinking fund categories and targets, but some people may still need some ideas on what kinds of targets they should choose.
Remember, these are just examples and the reasons why people use sinking funds are going to be different from one person to the next. Some of the more common ones are:
- Car sinking fund
- Holiday/special occasions
There will be many people who use some of these as targets, but if they aren’t a concern to you or a big deal, you can easily leave some out.
The first type of fund is for the home. This can include things like home repairs or renovations. Keep in mind, this does NOT include situations that are an emergency, such as a broken window or a leaking roof.
There’s a high chance you’ll know exactly what renovations you want to do and when you want them done. In order to figure out how much should go into this example, you’ll want to check prices for the renovation and see how much it would cost for a professional to do it and how much it would cost for you to do it.
Once you know the amount, you’ll be able to figure out how much you need to save every month.
The next example is a vehicle sinking fund. While this could be used to deal with upcoming work that will need to be done, most people will use this example to save for a new car.
Regardless of which one you choose, it’s important to know how much you’ll need to save.
This is a little bit easier for a new car because you’ll know the highest amount you’re willing to spend. Vehicle maintenance, on the other hand, can be a little tricky. Depending on what needs to be done, you’ll want to call around to different places to get quotes.
Once you know the amount, you can then start saving towards it.
One of the most common types of funds are ones that are geared towards vacation. While some people go every year, others can only afford to go every couple of years. It’s going to depend on your personal situation, but you want to make sure you save enough to have a fantastic time – by paying with cash and not coming home to more credit card debt.
The easiest way to do this is to decide where you want to visit, when you want to go, what activities you’ll want to do and what other things you’ll need to consider. It’s important to also have some spending money in case you see something you didn’t consider!
Holidays and special occasions come every year, but it doesn’t make them any easier. This is especially true for those that have a lot of these types of events close together or if you have a large family.
In fact, some holidays, like Christmas, can really drain your money quickly. With this being the case, you’ll have plenty of time to save what you need. In order to ensure you have enough, consider how many people you have to buy for and how much you want to spend on each.
From there, you’ll be able to figure out how much you need to put in every month.
The final example is for those that have upcoming medical expenses. These are ones that aren’t surprises or unexpected. They should be ones that you know are coming and won’t be happening for a few months.
A few examples would be:
- An upcoming surgery you’ll need
- An elective procedure
- Birth of a child
It’s important to see how much your insurance will cover and consider any costs that you’ll have to pay out of pocket. Once you know this amount, you can save what’s needed in order to ensure you have plenty to cover it.
The Best Accounts To Keep Your Sinking Funds
Finally, we’ll talk about where you should keep your sinking fund. While you could always keep them at your house under your mattress, putting it into some kind of account will give a little extra security.
The last thing you want is to save so much money towards your goals, only to lose everything for various types of reasons.
While it’s ultimately up to you, we’re going to take a look at 5 different types of accounts you can put the money in. These are:
- Certificates of deposit (CD)
- Money market accounts
- Normal savings account
- Completely separate savings account
There isn’t a right or wrong answer, so make sure you’re using the account that works the best and makes the most sense to you and your needs.
The biggest thing to keep in mind is when you may need access to your money. If you’re saving up for a house, you can tie up that money in a CD unlike if you’re saving up for unexpected vehicle repairs.
Don’t tie up your money into investment vehicles that you can not easily access if there is a chance you may need it for an emergency expense.
Certificates Of Deposit
The first type of accounts you can use are called certificates of deposit also known as CDs. When you purchase these types of certificates, they are guaranteed to gain interest over a period of time at a fixed interest rate but you can not withdraw the money early.
This is not a type of fund you want to use if you may need quick access to your funds.
Money Market Account
There’s also the option of using a money market account. These are accounts where the user deposits a certain amount of money and earns interest depending on the interest rates that are currently in the money market.
Since you never know exactly what the rates are, you don’t want to count on getting a certain amount extra each month. The best way to use these is by depositing the required amount every month, then using any interest as extra.
This way, you won’t be relying on the interest amounts, but you will be able to keep your money in a safe and secure place while making money on your money. You can also quickly access this money if needed.
Normal Savings Account
An option that’s extremely popular is a normal savings account. When most people sign up at a bank, they usually get a checking and savings account. Many people will just put the amounts in the savings account they have with their bank.
While this is a decent option, it takes a lot of discipline to make sure you aren’t dipping in for reasons that are different from your target.
Honestly, if you don’t think you’ll be able to hold off from doing this, it’s probably not the best option.
Completely Separate Savings Account
This is the option we currently use, although we should probably switch over to a money market. The reason we haven’t made the switch is because we aren’t saving up for anything long term at the moment so the money we would make from interest is minimal.
Also, I haven’t been able to convince myself that the effort to open a money market account is worth the small amount of interest I would gain from our current sinking funds.
The option that the majority of people go with is a completely separate regular savings account. This can either be at your normal bank or you can choose a completely different one.
Having a separate account means you’ll have an easier time only getting into the account for the targets you’ve set up. Clearly having separate funds for each sinking fund is the best way so you don’t accidentally mix up your money.
Sinking Funds vs Emergency Savings
Many people think that a sinking fund is the same thing as emergency savings or an emergency fund. The fact is that these 2 funds are similar but quite different.
With a sinking fund, you know exactly what you’re saving towards and you know exactly how much you put into it every month or pay period. An emergency fund, on the other hand, is a general fund that helps with any kind of emergencies that come up.
In reality, you should establish and fully fund an emergency savings account before you start to use a sinking fund. Sinking funds are best used after your emergency savings fund is full.
Sinking Fund vs Traditional Savings Account
There’s also a difference between a sinking fund and a traditional savings account. While these don’t have many differences, they do have 1 large one.
Remember, with a sinking fund, you’re saving towards a specific target or situation that you’re saving for. For a savings account, though, you’re more likely to be saving towards future financial goals or certain activities and experiences that you want to do or have.
For example, you might be using a sinking fund to save towards your yearly taxes, while you might be using a savings account to save enough money to put a down payment on a house.
While they can be used together, it’s going to take a lot more discipline to save what you need for your different goals. As a result, it’ll just make things easier if you have separate accounts.
Wrapping It Up
Not only do sinking funds allow you to be a little more prepared for most unexpected situations, but it can also help you meet your goals of making better financial habits.
For every little bit you save, that’s less you’ll have to potentially take out of your normal pay or the money that needs to be spent on your normal bills. It might seem like it’s just a simple little thing that isn’t that big of a deal, but for those that struggle, the stress of unexpected situations can really make life rough.
‘With a sinking fund, that’s just one less thing you’ll have to worry about and you won’t have to make yourself sick trying to figure out how you’re going to pay for the situation, as well as ensuring you’re making ends meet.
It might not answer all of your problems, but it can give you a little bit of extra hope and relief.