I recently asked my readers how they stick to a budget, and an overwhelming number of them said they use sinking funds. And they use sinking funds for all sorts of things: vacations, subscriptions, clothes, insurance premiums, holidays, and more.
But, what is a sinking fund and how does it work?
Sinking funds are a savings tool, but they’re more strategic and smarter than a generic savings account. It’s a way to intentionally set money aside.
Sinking funds eliminate the stress and guilt associated with making big purchases, as well as irregular and annual expenses. So let’s dig in to what sinking funds are and how they can help you stick to your budget.
What is a Sinking Fund? | Why It's a Smart Way to Save Money
What is a sinking fund?
A sinking fund is a strategic way to save money for upcoming purchases. It’s a way to plan out your spending for irregular expenses or large one-time purchases.
It’s saying, “Hey, I’m going to need money for _______. I’m going to start putting aside money now.”
You figure out how much you need to save, and then you start setting aside a predetermined amount of money each month for that expense. And then when you need the money, it’s waiting for you.
If that sounds familiar, it’s possible that you’ve been using sinking funds without realizing that’s what they’re called. It’s a really common way to save for vacations, a down payment on a house, holiday spending, and other big purchases.
The magic of sinking funds
Some people swear by sinking funds, and for a good reason. It’s money you don’t have to think twice about spending. You’re giving yourself permission to spend money while not worrying about what else it might go towards. That sounds pretty freeing, doesn’t it?
If you’re still confused about what I mean, let’s look at a hypothetical example:
I have a baby on the way, and I know there are going to be all sorts of things my wife and I will need to buy for him. We can plan and buy all the baby gear we want, but there’s always going to be something that comes up.
Maybe he doesn’t sleep well and we see a fancy new sleep sack that guarantees he’ll sleep all night long. After months of sleeping in two hour increments, you know we’ll want to try it.
With a sinking fund for baby expenses, we have money set aside for things just like that. I run to the baby store, buy the sleep sack, and all of our sleep problems are solved. I’m told babies don’t work this way, but I can dream.
When you set money aside for specific purchases, you don’t have to spend time thinking about where the money will come from – it's already there.
Without a sinking fund, we’d have to look over our budget and see where the money for the sleep sack would come from. Even though it’s a relatively small amount, we don’t want to put it on a credit card. I also don’t want to use money allocated for retirement savings or any number of other things.
A sinking fund gives you the freedom to spend money without stressing about it.
Sinking fund vs. savings account
Logistically speaking, there isn’t a huge difference between a savings account and a sinking fund. But there is a massive difference in how you think about and use the money.
Sinking funds are targeted savings – you’re putting money aside for a specific purpose. It’s not for random expenses, to have a financial cushion, or retirement savings. Sinking funds are more specific and for near-term purchases.
What to use sinking funds for
Remember that sinking funds are for targeted savings and things you know you will have to spend money on eventually. These expenses typically fall into one of the three following categories: large purchases, overlooked expenses, and unexpected events.
You can get a pretty clear idea of how much you want to spend on major purchases, but unless you save up for them, you might have to take out a loan or drain your savings. Here are some examples of large purchases you can save for with a sinking fund:
- A new car
- Down payment on a house
- Home remodel
- New furniture
Overlooked expenses are the ones that come up every year, but they’re easy to forget about until it’s too late. Here are a few examples:
- Personal property taxes
- Back-to-school shopping
- Holiday spending
- Insurance premiums
- New clothes fund
- Routine car maintenance
- Baby/kid expenses
These are expenses you can’t plan for entirely – which is why they’re called unexpected – but you know they will inevitably come up, like:
- Home repairs (new roof, water heater, clogged pipes, new AC, etc.)
- Car repairs
- Replacing or repairing electronics, like laptop or cell phone
- Medical expenses
There aren’t strict rules about how you create sinking funds, which means that some of them can overlap. For example, you could use one sinking fund for both car maintenance and repairs.
How do sinking funds work?
The basic premise is this: you decide what you want to use a sinking fund for, set aside money each month to be used at a later date, and repeat the process until you’ve funded your goal. Then the money is there when you’re ready to spend it.
But let’s break that down into actionable steps.
Step 1: Figure out how much you can save every month
Start with your budget and see how much money you can realistically save every month. Because sinking funds help you prepare for upcoming expenses, you’ll eventually be able to save more money each month because some of your spendings will be pulled from sinking funds.
M$M tip: If you want to start saving more money each month, I highly recommend a side hustle. There are legitimate ways to earn an extra $1,000 a month in your spare time. Read more at 22 Best 2020 Side Hustles Ideas (Make $1,000+ Per Month).
Step 2: Decide what you’ll save for
The amount of money you can realistically save each month might be a factor here, so you may have to prioritize your sinking funds.
We’re going to pretend you have $400 to save each month, and you’re going to save for Christmas gifts, a new phone, home repairs, and your car insurance premium.
Step 3: Determine out how much money you need to save each month
Start by determining how much you should save for each of those funds, and then divide that up into monthly amounts.
- Christmas shopping: $500 total, or $40/month
- New phone: $600 total or $50/month
- Home repairs: $1,800 total or $150/month
- Car insurance premium: $2,000 total or $160/month
Step 4: Put money aside each month
One of the easiest ways to save for your sinking fund is to set up automatic bank transfers. You can set them up to transfer at the beginning of the month to pay yourself first, and this way you never forget to put money aside.
Step 5: Use your sinking fund when you need them
The sinking funds for your Christmas spending and car insurance premium will be used by a certain date. And using the money is as simple as taking the money out of your account and spending it.
But for your home repairs and new cell phone funds, a couple of things might happen:
- You need the money before you’ve reached your savings goal. In this case, you spend what you have, and then decide how you will make up the difference. You might need to borrow from savings, your emergency fund, another sinking fund, or find a quick way to make extra money.
- You reach your savings goal and don’t need the money for a while. You can let the money sit, and start allocating the amount you were saving to something else.
It’s possible that you will end up reaching your savings goals for multiple funds. That’s awesome.
But don’t forget to replenish your sinking funds as needed!
Where should you save your sinking fund?
Using separate bank accounts is one of the best ideas because it prevents you from using that money for anything else. Online savings accounts are a good bet because they often have zero fees, no minimum balance requirements, and you can usually earn a little money on your savings with a higher than average annual percentage yield (APY).
Money market accounts are another option to earn interest on your savings, but some have high minimum balance requirements.
Some people even like to use cash savings for their sinking funds – think cash in a jar or envelope. If seeing that cash add up keeps you motivated, then it’s worth a try.
Use a savings app for your sinking fund
Technology has made it easier than ever to budget and save money, and here are a few apps that can help you save for your sinking fund:
- Twine: This app lets you and a partner create savings goals and then save together. Learn more at Twine App Review: Money Saving Solution for Couples.
- YNAB: This is a zero-based budgeting app that helps you give a job to every last penny you earn. You use the app to budget your money and can create categories for each of your sinking funds. It’s also a M$M reader favorite.
- Qapital: This savings app uses rules and triggers to help you save money. Qapital also has options for investment accounts. Learn more at Qapital Review 2020: Save Money Without Even Noticing.
What is a sinking fund? – The final word
Sinking funds are ultimately a tool you can use to gain control of your financial life. They help you budget for big purchases, irregular expenses, and unexpected events.
So if you’re looking for a smarter way to save and spend your money, a sinking fund is worth a try.