Okay, so this post is going to be controversial. So let me just put a BIG OL DISCLAIMER here at the top for everyone to read. I dislike sinking funds….mostly, I just hate the name. The term “sinking fund” sounds super technical, and finance-y, and I think it makes things unnecessarily complicated when it comes to managing personal finances. I've never used them and probably never will.
WITH THAT SAID – a lot of people do use them and like them. And I get questions from time to time so I wanted to provide a brief overview in case you think they might work for you. I don't know. Some people put their pants on the right leg first, others on the left. Who can say why people feel such an affinity for the sinking fund?
What is a sinking fund?
How to Create a Sinking Fund
When you’re creating a sinking fund, decide ahead of time how much money to put into it.
- Even if you don’t know ahead of time exactly how much money you’ll need, it’s good to estimate. Otherwise, the “sinking fund” methodology just won't work.
- Once you have a number, divide it by 12. That’s how much you’ll be putting into it each month.
- If you’re saving for something that isn’t an annual expense, use the number of months away it is and divide your total by that.
For example, if you know you’ll need a replacement computer in 3 years, Take the number you plan to spend and divide it by 36. That’s how much money you’ll set aside each year for your “computer sinking fund.”
And then you rinse and repeat for all expenses you want to save up for (like Christmas, or vacation). The point of a “sinking fund” is that you'll use this money to spend one day. It definitely will get spent.
What Can a Sinking Fund Be Used For?
If you can think of a reason you might need to save for something, a sinking fund can be used for that, but there are some common sinking funds. Anytime you have big expenses that happen on a regular basis, that’s when you’ll put money aside. So, for example:
One of the most common sinking funds is the vehicle. Whether you’re saving for a new car, or know you need to replace your tires every year, cars can get expensive. (Here's how I saved close to $5k by getting by without a car for over two years.)
Another smart sinking fund to have is a medical fund. While you may not know exactly what expenses will come up, you plan to spend a large amount of money on medical bills. The best way to come up with a number for medical expenses is to audit what you’ve spent in the last 3 years and average it out.
Christmas and Gifts
One fun expense that comes every year is Christmas. If you take some time to think about it, you can figure out how many people you usually get gifts for each holiday season. You can either decide to spend the same amount of money on each person or have a few people that you spend more on than others.
During the rest of the year, you’ll have birthdays and weddings that require gifts. (Maybe even travel for a wedding in our post-Corona world!) Creating a gift sinking fund can help you make sure you won’t have to scramble for cash when the occasion arises.
Other categories include:
When Should You Use Your Sinking Fund?
Sinking funds are best for when you can determine what they’ll be used ahead of time. In other words, you’re putting money aside for a planned expense. Any time your planned expense comes up, that’s when you dip into it.
Let’s say you’ve created a vacation sinking fund. When your scheduled two weeks off arises, it’s time to use that fund!
Time to get snow tires to prepare for the winter season? That’s when you’ll use your vehicle maintenance sinking fund. Etc. etc.
Types of Sinking Fund Accounts
You’ll want to put the amount you set aside in a separate account. Don’t just put it into the same account as your checking or normal expenses.
The type of account you choose for your sinking funds will depend on why you’re using it.
However, you’ll likely want to keep it in a liquid account, as this is a fund you’ll be pulling from when expenses arise.
The best bet is to keep your sinking funds in a separate savings account or a high-yield account.
How They Differ From Emergency Funds
Emergency funds and sinking funds are similar, in that they’re pretty much always intended for spending. However, sinking funds are for planned expenses. Emergency funds are allocated for unexpected expenses.
- Let’s say you suddenly get a hole in your roof after a particularly nasty storm. That’s when you’d use your emergency fund.
- On the other hand, when you know it’s time to replace your roof once the old one has aged too far, that’s when you’d use your home maintenance sinking fund.
Whatever you might need a sinking fund for, planning ahead now will help you avoid
scrambling to come up with the funds once the expense arrives.