Does your bank account ever reach that place of Zen where everything seems to finally be in a good place … but then wham! You suddenly need to buy new tires or make some other one-time large purchase for the year?
While it’s true that 43% of Americans currently can’t cover a $1,000 expense, according to US News, you don’t have to let this be your reality. Even though most financial professionals recommend having an emergency fund set aside for such occasions, there’s another layer of buffer we could add to protect ourselves from financial ruin called a sinking fund.
In this post, we’ll explain what a sinking fund is, how it works, and why you might consider adopting it as part of your budgeting strategy.
What Is a Sinking Fund?
A sinking fund is money you intentionally set aside over time for specific future expenses. To say it another way, instead of scrambling when a bill shows up, you slowly “sink” money into a designated savings bucket until you need it. This way, when the bill does finally arrive, you’ve already got the cash to take care of it.
What Do You Use a Sinking Fund For?
In general, sinking funds should be used for any upcoming expenses that don’t regularly recur each month. You don’t have to necessarily know exactly when they’ll be here. You just have to anticipate that they will be coming around the corner within the year.
If you’ve ever thought to yourself, “Why does this expense always catch me off guard?” then that’s probably something that deserves a sinking fund. Here are some common sinking fund categories:
- Car insurance premiums
- Vacations
- Holiday gifts
- Birthdays and weddings
- Property taxes and homeowner’s insurance (if they aren’t already part of your mortgage escrow)
- HOA fees
- Back-to-school shopping (if you have children)
- Planned home maintenance
- Appliance replacement
- Planned vehicle maintenance (such as new tires or an engine tune-up)
- Pet care
- Kids’ activities or sports
- Etc.
How Is a Sinking Fund Different from an Emergency Fund?
You might be saying to yourself: Isn’t this what my emergency fund is for?
Not exactly. Emergency funds could be used for expenses like these. But really, its purpose is for true, unexpected “emergencies” such as:
- An urgent vehicle repair so that you can continue to go to work
- Large medical bills not fully covered by insurance
- A job loss
- A problem with your house that makes it unlivable (such as a leak in your roof or a broken furnace)
The key distinction between the two is planned vs unplanned. Here is an example:
- If you can see that your tire tread is getting low and they’ll probably need to be replaced within the next six months, then that’s an expense you can prepare for using a sinking fund.
- On the other hand, if your vehicle is driving fine but suddenly has a problem that needs to be fixed urgently, then that might be financed with your emergency fund.
With proper positioning, your sinking fund may serve as the first line of defense for non-regular expenses. That could make it so that you hardly access your emergency fund, leaving it for only those times when a true emergency requires its usage.
What Are the Benefits of a Sinking Fund?
As a financial tool, a sinking fund can be very useful. In fact, you may be surprised to learn that businesses use them all the time to plan for large, future expenses. Hence, if you think of your household finances as a small business, then it can make sense to utilize them.
Here are a few good reasons why a sinking fund might be useful:
- Less stress. When a sizeable bill shows up, it won’t catch you off guard. You’ll have zero worries because you’ll already be funded and ready to pay it off
- Reduced reliance on credit cards. If you’re someone who turns to credit cards to cover unexpected expenses, then a sinking fund can be a lifesaver. You’ll be able to pay off that portion of the balance without it becoming part of your revolving balance and accruing interest charges.
- Better control over your money. Sinking funds are an extension of your budget. As you’re planning out what you’re going to spend your money on, you’ll have a clearer perspective of your complete financial picture. That means you’ll be able to allocate additional resources where you want them to go without having to dip into them otherwise.
How Do I Start a Sinking Fund?
Starting a sinking fund is a relatively easy thing to do. To get started, try the following:
- Set up a separate account. Similar to your emergency fund, it helps to make your sinking fund something that’s “out of sight, out of mind.” Therefore, it’s strongly recommended that you open a new savings account that’s separate from your checking account and emergency fund. Bonus tip: Pick a financial provider that offers high-yield interest so that it makes a few extra dollars as the funds accumulate.
- List your future expenses. Think about the next 6 to 12 months of upcoming expenses that aren’t part of your normal monthly budget. Write down as many as you can think of.
- Assign a value. For each expense, write down how much you expect each one to cost. Try to be as accurate as possible using previous bills as a benchmark. If you truly don’t know, then give it a conservative estimate.
- Determine a timeline. Based on each of your expenses, how many months will there be until you need funding? Write this down for each item.
- Break up your savings into monthly amounts. For each expense, divide its value by the number of months until it occurs and its timeline. For example, if you wrote $1,200 for holiday spending and there are 12 months until you need the money, then you should put $100 per month towards this goal into your sinking fund.
- Automate contributions. After the framework has been determined, set up your checking account to regularly move the necessary funds into your sinking fund. Think of the debit like any other bill that must absolutely be paid.
Final Thoughts: Why Sinking Funds Are a Game Changer
Your budget doesn’t have to implode every time a major expense comes your way. You can get ahead of it by anticipating the predictable ones and allocating funds accordingly.
Remember, a sinking fund is an extension of your budget. It’s there to help cover expenses so that your emergency fund doesn’t have to. Though it will take some additional planning and effort to put a sinking fund into practice, your future self will be glad you did.
Featured image credit: Pexels
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