You probably know what an emergency fund is but do you know what a sinking fund is? A sinking fund is just as important as an emergency fund. We will tell you what it is, what it’s for, and how to build one. You don’t have to go down with the ship if you have a sinking fund.
You are pretty financially savvy, you’ve been an LMM fan for years. But there is a new personal finance term being bandied about that you might not be familiar with. We’re going to introduce you to sinking funds.
What is a Sinking Fund?
Emergency funds are pretty self-explanatory. They are money you set aside for an emergency, something unexpected like a job loss, a car repair or medical expense. The key word is unexpected. An emergency fund insulates you from things you didn’t see coming.
A sinking fund is for expected expenses. Things you know are coming but don’t come along very often, so aren’t in your regular budget. But you know the expense is coming, when it’s coming and at least an idea of how much it will be.
By creating a sinking fund, those expenses will be accounted for in your monthly budget.
One common mistake is that people forget to put things in their budget. You may leave out things like gifts, haircuts or annual bills. If you have not planned or budgeted for the expenses, it can really hurt you when it is time to pay for it.
A sinking fund can also be a way to budget for a short-term goal.
What Do You Use a Sinking Fund For?
A sinking fund is for yearly expenses like taxes and holidays that require gifts like Christmas and birthdays. Those things happen on the same date (around the same date for taxes) every year, so it’s not as if they are a surprise.
If your car is giving you more and more problems, you know that it’s not going to last forever and that it will need replacing soon. You can’t know precisely when it will give up the ghost but you know it’s coming and probably sooner rather than later.
Unlike an emergency fund, a sinking fund can also be used for fun stuff like a vacation.
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How Much is in Your Sinking Fund?
To determine how much you need in your sinking fund, take the cost of the thing you need the money for and divide it by the months you have left until you need it.
You want to buy a new sleeper sofa before Christmas because you will have family staying with you. The sofa costs $725, and it’s currently April. Divide the cost of the sofa by the number of months you have to save for it.
In this example, you need to save $80.55 for the next nine months.
Not an Exact Science
Sinking fund math isn’t always straightforward.
In our new car scenario, we know how much we can afford for a new car, but we don’t know when we will need to buy it. That depends on how much longer our current car remains drivable.
In cases where you can’t know the exact amount of money you are going to need or the amount of time you have to save it, the best you can do is to make an educated guess.
While you know how much the flights and hotels are going to cost for your upcoming vacation, you don’t know exactly how much food is going to cost.
But you can get a pretty ballpark idea with a little research.
You probably don’t plan every restaurant you’re going to eat at in advance, but you have a few on your list of “must eats.” It’s easy to find restaurant menus with prices online.
You can look up how much things like a glass of wine and a cup of coffee run in the city you are visiting and break it down by neighborhood for more detail.
If it’s the timing you can’t know, you want to base your sinking fund plan on how essential the item is. If it’s your car and you have no other way of getting to work, then you better save as much as you can as quickly as you can.
You might also consider padding your sinking fund with a little extra money. There will be “unexpected, expected” expenses because we all forget things sometimes. You don’t usually buy your parents an anniversary gift but this year is their 40th, and they are having a big party.
These things can happen so it’s a good idea to have some money for them too.
Where to Sink It (see what I did there?)
Sinking fund expenses are typically short term. These are things you need to pay or buy within a few months or at most, a few years. Your retirement fund, for instance, is not a sinking fund.
It’s never a good idea to invest short-term money because it doesn’t have time to ride out the ups and downs in the market.
So yes, your sinking fund is going to have to be kept in a wonderfully accessible but horribly underpaid checking or savings account earning the not so generous 0.000001% interest that most banks offer.
You may want to use a separate account from your regular checking or savings account so your sinking fund isn’t mingling around with your regular spending money and tempting you to spend it on something other than what it is intended for.
If you do open a separate account, be sure it is a free account. Many banks charge a fee if you don’t keep a minimum balance and the amount of your sinking fund may not reach it.
There is no need to open a separate account for each different sinking expense. It’s too much to keep track of.
All you need to separate are the budget categories in your Mint account or wherever you keep your budget. Every month you budget $50 for the category “Christmas Presents” and $100 for the category “New Sofa.”
What About Debt?
We always stress that your high-interest debt is an emergency and it is. You need to focus on paying it off with the stacking or the snowball method. But an emergency fund is necessary too because if you don’t have one and an emergency pops up, what will you do?
You could be stuck putting the expense on a credit card, or worse, taking out a predatory payday loan. Even if you have debt, having $1,000 saved for an emergency fund is good advice.
Does the same apply to a sinking fund?
It depends on what the money is for. If it’s for a new set of tires that you don’t need immediately but you are going to need soon, yes because the tires are a necessary expense and you are going to have to come up with the money from somewhere, so it’s better to have it in cash than to use a credit card or a payday loan.
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If it’s for a vacation, no. You can’t afford to take a vacation when you have high-interest debt.
We might feel a lot of pressure to save up an emergency fund because the unknown is always scarier than the known. What if we were to lose our job? How would we live? That can really light a fire under you to buckle down and get that money saved.
Saving for a sinking fund seems less urgent. Yeah, yeah, I need to start saving for Christmas. It’s months away though, I’ll worry about it in a few months.
And of course, Christmas manages to sneak up on you despite the fact that it has happened on December 25th for hundreds of years and you are surrounded by it no matter where you are from about October.
That’s why a sinking fund is urgent. You don’t want things sneaking up on your and wrecking your budget.
Setting Up Your Sinking Fund
Setting up your sinking fund isn’t complicated.
- List out all the things you need or want to save for and how much money you need.
- Determine when you need the money.
- Divide the amount of money you need by the number of months until you need it.
- Make a category in your budget for each expense.
- Open a separate bank account if necessary to house your sinking fund.
- Set up automatic transfers from your checking account to your sinking fund account.
It’s Not Overkill
We believe in keeping finances simple. So creating a sinking fund and opening a new account to keep it might seem unnecessary. Something making your finances more complicated than they need to be.
But having a sinking fund really is an essential part of your overall financial plan. It’s every bit as important as your emergency fund and retirement fund.
Every dollar we earn should have a job. The dollars in our emergency fund insulate us from the unexpected.
Those in our retirement account give us money to live on when we are no longer working. The ones in our sinking fund protect our regularly monthly budgets from being screwed up due to lack of planning.
With a job as important as that, having a sinking fund is not overkill, it’s something everyone should have.