Sinking funds are tools that people or businesses can use to set aside money for a planned expense. For example, if you want to take a vacation next year, you may start putting cash in an envelope to save up for the trip.
Sinking fund categories can vary by person, depending on their relevant expenses. They can include auto repairs, health care costs, gifts, insurance payments, vacation funds, and more.
You can think of sinking funds as a way of “sinking” your money into an account for later use. It’s basically a savings strategy. Find out more below.
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Key Points
• Sinking funds allow you to save for large expenses over time so that paying those bills isn’t so stressful.
• You might use sinking funds to save for purchasing holiday gifts, leasing or buying a new car, or funding your next vacation.
• A sinking fund is part of your budget, and the contribution amounts can be calculated in many ways — whatever works best for you.
• You can keep your sinking fund money in cash or put it in a designated bank account.
• You might want to contribute more to your sinking fund when you have extra income, such as when you get your tax refund.
General Definition of Sinking Funds
The term sinking fund has its roots in the world of corporate finance, but it mainly refers to setting aside money for a future expense.
Sinking funds are smaller offshoots of an overall budget. Putting together a sinking fund entails stashing your money away to spend it on a predefined purpose later on.
For instance, some people like to pay their car insurance in six-month installments. They may set aside money each month in anticipation of the next six-month installment payment so that they’re not hit with a big expense all at once.
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Examples of Sinking Funds Categories
When it comes to sinking fund categories, there are no hard-and-fast rules. Different individuals have different financial needs and planned expenditures. Some common sinking fund categories are:
• Vacations
• Gifts and holiday-related expenses
• A new car or regular maintenance and insurance costs
• A home purchase or home maintenance expenses
• Medical and dental costs
• Child care costs
• Tuition fees
• Pet expenses, such as veterinarian visits
A sinking fund can help you save for just about anything.
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Sinking Fund Category Calculations
Setting up a sinking fund is simple enough: You can set cash aside or choose a more formal option like a savings account. The difficulty for most people is regularly contributing to it. The trickiest part, though, may be figuring out how much to put away.
A budget planner app can come in handy, allowing you to assess how much money you have left to put toward your sinking fund categories once you’ve taken care of your monthly expenses.
Similarly, sticking to a certain budget type — such as the 50/30/20 rule — may help determine what you can contribute. You could also structure your sinking fund contributions as a biweekly savings challenge.
To calculate how much you can contribute to a sinking fund, you’ll need to decide which categories are the most important. Another consideration is which fund to use first — perhaps an auto insurance payment is due before a vacation. Your priorities will affect your sinking fund calculations.
In corporate finance, the sinking fund formula helps a company figure out how much it needs to put away to pay off a long-term debt in a lump sum. The formula takes the amount of money already accumulated, multiplies it by any applicable interest, and then divides it by the remaining number of payments.
For individuals, however, the calculation can be as simple as looking at your monthly income and putting extra cash into each of your sinking fund categories.
Types of Sinking Funds
What type of vehicle can you use to save up for a sinking fund? There are a few to choose from.
The most obvious, and probably the simplest, is to keep the sinking fund in cash and store it somewhere safe. Of course, that money won’t earn any interest and will likely lose value due to inflation.
Perhaps the ideal option is to open up individual savings accounts at your financial institution for each of your sinking fund categories. This beats cash because your sinking fund is protected (and insured up to $250,000 by the Federal Deposit Insurance Corporation or the National Credit Union Administration), and you might also earn some interest on it.
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Best Time to Take Advantage of Sinking Funds Categories
Sinking funds are all about taking advantage of saving up for a planned or known expense well in advance. As such, the ideal time to use your saved money is when it’s time to make the payment, be it a fancy vacation, a new car, or paying your child’s college tuition fees.
There may be times during the year when it’s more advantageous to save than others. For instance, most people experience a financial crunch during the holiday season — with gifts to buy, parties to attend, and other demands on income. That may not be the best time to sink money into a fund.
Instead, think about when you may have some extra money to put into your sinking funds, such as when you get your tax refund or receive a cash gift for your birthday.
The Takeaway
Sinking funds are designated cash reserves for future expenses. Corporations and businesses also use sinking funds. Having this type of fund means that you’re stashing money away for an upcoming, known expense and relieving some of the financial pressure ahead of time. Sinking fund categories can vary depending on your individual situation.
Sinking funds are a way to get ahead of your planned expenses and give yourself some financial wiggle room. A money tracker app can help you do the same.
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FAQ
What to put in sinking funds?
You put cash into a sinking fund to use later for an upcoming expense. What that expense is (i.e., the sinking fund’s category) depends on your specific financial needs.
What is a sinking fund leasehold?
In property management, a sinking fund leasehold contains funds for repairs or renovations to a rental property. The leaseholder or landlord sets aside a small percentage of the monthly rental money to continue adding to the fund.
What is the difference between a reserve fund and a sinking fund?
The two are similar, but a sinking fund’s contents are designated for a specific purpose or expense, while a reserve fund contains funds used for general future expenses.
What is the difference between an emergency fund and a sinking fund?
An emergency fund is a general fund set aside for sudden, unexpected expenses, such as job loss and medical bills. In contrast, sinking funds are meant to finance expenses that you plan for.
What is a common sinking fund mistake?
People may sometimes split their sinking funds into too many categories and find it overwhelming to put money into each. The right number of sinking funds for you will depend on your finances and your individual needs.
Photo credit: iStock/Delmaine Donson
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