You’ve probably heard the term “sinking fund” thrown around a lot lately. It seems to be the new buzz word in the personal finance space. But what is a sinking fund?
A sinking fund is simply a fund that you pay into over a period time with the intent of paying for a future expense or to pay off debt.
Though primarily leveraged by corporations, this method of saving over time has found its way into personal finances.
Sinking funds can virtually be used for anything. From funding new cars, home repairs, Christmas, to vacations.
The concept is very simple: save a little bit over time.
Sinking fund vs savings account
A sinking fund shouldn’t be confused with a savings account, because the two are different. The thing that differentiates them is that a sinking fund has the sole purpose of being spent.
When you put money into savings, the purpose is risk mitigation. You want to have money set aside in case of an emergency; however, the plan (and hope) is that you never have to spend it.
Ultimately, when this money goes unspent, it contributes to your overall wealth building. Because of this, the goal is to maximize your potential for growth for your savings account. That’s why I recommend putting your emergency fund into a high-yield savings account.
Where to put your sinking fund?
Where you put your sinking fund will all depend on your goal.
For instance, if you’re saving up for a $1,500 DSLR camera that will only take a few months to save up for, then a traditional checking account will work. In this case, you won’t reap the benefits of interest because the amount is relatively small.
Contrarily, if you’re saving up to buy a new car, the ideal location may be a money market account or a high yield savings account. In this case, you will reap the benefits of interest and be able to earn a few dollars on your money while it’s in the account.
Though you would need to likely transfer the money from a savings account to actually pay for your expense, a money market account comes with the option of using a debit card or check.
I recommend opening a separate account for each fund that you’re creating. In fact, that’s why I recommend having at least five bank accounts. Doing so allows you to organize each fund so you know exactly how much you have put aside for that expense.
How many sinking funds should you have?
There is no rule of thumb when it comes to how many sinking funds you need. It’s completely based on your own personal goals and expenses.
Generally, I would steer away from excessive funds that would make saving difficult. For instance, if you only have $1,000 in extra cash to put toward your funds, you don’t want to have that spread across twenty accounts. That’d make it hard to save efficiently.
Nonetheless, there are a few funds that I think every adult should have at some point in their financial journey.
If you already own a home, then you’ll understand the importance of having money set aside for repairs, renovations, and even decor.
We typically set aside $25 per pay period to cover these expenses and other things, like mulching our yard or having our home pressure washed. This means that we don’t have to make additional concessions in our budget to pay for these yearly expenses.
This fund is also practical if you’re saving up for a home. Maybe you’re paying off other debt but still want to put some money aside. Having a sinking fund for your home is ideal for this situation. In this case, you’d put your money away in a high yield savings account, as it is a longer-term goal and you’d benefit from interest.
At some point, you’ll need to replace your car. They are depreciating assets that not only lose value over time, but they also deteriorate mechanically. Knowing this, you should save ahead of time.
You don’t have to use this fund exclusively for a new car. It could be for car maintenance and repairs, registration, or even taxes. Simply setting aside a few dollars a month for things related to your vehicle can make a huge difference.
Traveling becomes much less of a burden when you save for it over time. For instance, if you know that you’ll be taking a yearly vacation, why not put a little away each month to save for it?
Since travel does require spending on things like flights and hotel stays, I suggest putting this fund in a checking account. While traveling or on vacation, you’ll exclusively use that account to pay for things and not worry about going over budget.
Birthdays, Christmas, and anniversaries all come every year. So instead of having to squeeze gifts into the budget or go into debt, just set up a sinking for exclusively for these things.
Holidays are much less of a burden when you already have a set amount of money put away to pay for things. This also helps you put a limit on your spending, as you can only spend what’s in the account.
This is a fund that we’ve not yet set up, but fully intend on doing. It should go without saying, but children are expensive. Childbirth or adoption is also expensive, which is why a sinking fund is a great thing to have.
In our case, we plan to set up a sinking fund to cover expenses related to childbirth and buying things like strollers, bassinets, and everything else that babies need. Though many items may be gifted, it’s a great idea to have funds set aside to cover those expenses related to children.
If your kids are a bit older, you may have this fund for things like camps, extracurricular activities, or even school clothes. The options or infinite on what this fund can be used for.
How to set up a sinking fund
Setting up a sinking fund is quite simple. You’ll just need to determine what funds you’ll be setting up and where you want to put them. The most challenge part is determining how much to put aside.
- Determine what funds you want to have
- Open a corresponding bank account for each fund
- Determine how much you’ll put in each account
- Automatically transfer this money into each account each month
How much should you put in your sinking fund?
The amount that you put into each fund will largely depend on how much free cash flow you have after expenses are paid. For instance, you may have $1,000 left at the end of each month after all of your bills are paid.
From that $1,000 you’ll decide how much should be allocated toward each account. This number will depend on which expense needs to be funded first and which one needs the most money.
Divide that $1,000 among your sinking funds:
- $300 for House Fund
- $175 for Car Fund
- $150 for Travel Fund
- $150 for Christmas Fund
- $225 for Kid’s Fund
These numbers are completely arbitrary, but give you an example of how you can divide out your extra money to put toward your sinking fund.
If you consistently save this amount each month for each fund, you’ll have a total of $12,000 saved for the year with money for each fund put aside.
- $3, 600 for House Fund
- $2,100 for Car Fund
- $1,800 for Travel Fund
- $1,800 for Christmas Fund
- $2,700 for Kid’s Fund
The other way to decide how much to put aside each month is to have an actual target amount for each fund for the year.
For instance, you may only want to save and spend $750 dollars for Christmas. In this case, you’d just divide your target by 12 months to determine how much you should save each month. In that scenario, you only put aside $62.50 per month instead of $150 per month.
If you know how much your expense will require, I suggest using this reverse method. This ensures that you hit your target and are able to cover the expense.
If you’re ready to start your own sinking fund, you can grab my budget spreadsheet that includes a savings tracker. It’s a fun way to track how much you’ve saved and how much you have left to reach your goal.