It may sound like a negative thing, but a sinking fund is money that’s saved toward a specific goal. Governments and businesses can use sinking funds to hold reserve cash to fund future expenses, but this kind of account also has a place in personal finance as you build wealth and achieve goals.
What sinking funds are is a way to earmark and stash money so you can, say, buy a new car or take an amazing vacation. Understanding how a sinking fund works can help you decide if you need to include them in your budget.
Here, you’ll learn:
• What a sinking fund is
• How sinking funds work
• The pros and cons of a sinking fund
• How to start a sinking fund
• How sinking funds differ from other kinds of savings
• Alternatives to sinking funds.
What Is a Sinking Fund?
A sinking fund is money that’s earmarked to pay planned expenses that fall outside of your regular budget. In accounting, a sinking fund is used to save money to pay debt or replace an asset that is declining in value. The name, which can admittedly sound negative, may be derived from the idea of sinking, or paying off, a debt.
As mentioned, individuals, businesses, and even governments can use sinking funds to hold money in reserve for future expenses. For example, the U.S. Treasury Department maintains a sinking fund for unused appropriations.
But for an individual, the meaning shifts somewhat. So what is the purpose of a sinking fund? Simply, it’s to help you be financially prepared so that when the time comes to pay certain expenses that are on the horizon.
If you have a sinking fund, you have the cash on hand and aren’t scrambling to come up with the money. Sinking funds can help you avoid having to turn to high-interest credit cards or loans to cover expenses that don’t fit into your regular budget. Being able to avoid debt is one of the main reasons why saving is important.
How Do Sinking Funds Work?
Sinking funds work by allowing you to set aside money periodically toward specific expenses or goals. You decide which expense or expenses you need to save for and the amount you want to save.
Do you know you’ll be needing a new washer/dryer pretty soon? Or perhaps there is a destination wedding you were invited to and it’s going to cost a chunk of change. When you see these kinds of expenses on the horizon, a sinking fund can help. You save money towards that expense until you reach the full amount, according to a schedule you set for yourself.
For example, you might be saving money from your salary weekly, biweekly, or monthly. Once it’s time to pay the expense, you can take the money from your sinking fund to pay for it. If it’s a one-time expense, then you’d be done saving money in that sinking fund. But if it’s a recurring expense, then you might start the cycle of saving over. Let’s say you’ve enrolled in an adult-ed program which could lead to your earning a certificate. You could earmark funds, use them up to pay tuition, and then start saving for the next semester.
You can have one general sinking fund to use for pre-planned expenses or multiple sinking funds. Having multiple sinking funds allows you to finetune your savings targets. However, you’ll need to be organized to keep track of where your deposits are going and what’s coming out of your funds.
Common Examples of Sinking Funds
What are sinking funds good for? A sinking fund can be used to save money for a variety of expenses. Some of the most common sinking funds categories include:
• Vehicle maintenance and repairs
• Pet care
• Home maintenance and repairs
• Birthdays, holidays, and other special occasions
• Wedding expenses
• Baby expenses
Those are just a few of the things you might need a sinking fund for. The number of sinking funds you choose to establish can depend on your financial goals. You might create one for, say, a down payment on a home or a trip to Bali. It’s up to you.
Where Can You Keep a Sinking Fund?
When deciding where to keep a sinking fund, accessibility matters. You need to be able to add money to your sinking fund and withdraw it when needed. For that reason, you might open an online bank account to hold your sinking funds.
With an online savings account, you can earn interest on deposits and link your account to checking for easy transfers.
Some banks allow you to open a main savings account with multiple sub-accounts. You might choose this option if you’d like to be able to add money to individual sinking funds for specific expenses. Sub-accounts can allow you to see all of your sinking fund money in one place while keeping goals separate.
A money market account is another candidate for holding sinking funds. These accounts can earn interest like a savings account but they may offer check-writing abilities or debit card access, which you typically don’t get with a savings account. Just be sure to check if your bank limits the number of withdrawals you’re allowed to make from a money market account. For some people, this factor (if it exists) can be a deal breaker.
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Pros of Sinking Funds
Setting up sinking funds can offer some advantages if you have planned or recurring expenses. Here’s what’s good about sinking funds:
• You can use them to create a structured plan for saving toward various expenses or financial goals.
• Depending on where you keep your sinking funds, you may be able to earn a decent rate of interest on your deposits.
• Sinking funds ensure that when a planned expense comes due, you have the money to pay it. You can avoid dipping into your emergency fund or using a credit card.
Cons of Sinking Funds
Sinking funds can help you to be consistent with saving, but there are some potential drawbacks. Here are the main cons to know about sinking funds:
• You have to be organized and disciplined when setting up a fund or multiple funds, if you want to establish different savings accounts or sub-accounts.
• If you’re also saving or investing in other accounts, you may have trouble keeping track of what is sinking fund money and what isn’t.
• Saving in multiple sinking funds could leave you spread thin financially if you’re not careful about budgeting.
Tips for Starting a Sinking Fund
Getting started with sinking funds isn’t that difficult. Here are a few simple tips for using sinking funds to save toward planned expenses.
List Your Sinking Fund Categories
The first step in creating a sinking fund is deciding what categories to include. A good way to choose sinking funds categories is to review your spending for the last six months to a year. Look for expenses that may recur periodically, like biannual or annual insurance premiums or annual home maintenance.
From there, consider what savings goals you might be working toward that are one-time expenses. That may include a wedding, a down payment on a home, a vacation, new furniture, or something else you only expect to pay for once. You can then use your recurring expenses and planned expenses to create your sinking fund categories.
Determine Your Savings Target
Next, decide how much you need to save toward each expense or goal on your sinking fund list. Assign an overall dollar amount first, then determine how much you need to save monthly, based on when you plan to spend the money.
Let’s say you want to save $1,000 for a trip you’d like to take in a year. You’d divide the total by 12, and your savings goal would be $83.33 per month.
Decide Where to Keep Sinking Funds
Once you know what you need to save each month, you can choose where to keep your sinking funds. Again, this may be a single savings account or money market account, or a savings account with multiple sub-accounts.
Certificate of deposit accounts are usually not the best place to keep sinking funds. They require you to leave money in them untouched for a set maturity term to avoid a penalty. You may be able to find an add-on CD account that is a work-around to this. These accounts may allow you to increase the funds on deposit; check with a financial institution that offers this product for more details.
Set Up Automatic Transfers
If you’ve opened sinking fund accounts, you can take the final step and link them to your checking account. You can then schedule recurring automatic transfers from checking to your sinking fund account each month to grow your savings automatically.
You might want to set up your automatic deductions for payday. It can be helpful to have the money whisked out of your checking account and into savings before you see it and think about spending it.
What Amount Do I Need to Put Into a Sinking Fund?
When thinking about sinking funds, you’ll likely wonder, “How much money should I be saving each month?” The answer will depend on your goal. If you know you need to save $1,200 to pay your annual car insurance premiums, for example, then you’d need to set aside $100 per month toward that amount. Meanwhile, if you’d like to save $12,000 for your wedding which is two years away, you’d need to save $500 per month for that sinking fund.
You can go back to your list of sinking fund expenses and determine the monthly amount you need to save toward each one. You’d just need to add up all of those smaller amounts to figure out the total amount to save each month. Of course, you may need to do some juggling to be able to afford your goals. You might decide to downsize one goal or stretch the timeline on another one if you feel you’ve set the savings bar too high.
Sinking Fund vs Emergency Fund
You may be tempted to dip into your emergency fund for some expenses, like, say, buying a high-tech exercise bike. However, a sinking fund may be a better option. While a sinking fund and an emergency fund are both designed for saving, they serve very different purposes.
With a sinking fund, you’re setting aside money regularly that you plan to spend at some point. Some sinking fund expenses may be one-time; others may be recurring. An emergency fund, on the other hand, is designed to hold emergency cash in case you have an unexpected expense that you need to cover. Emergency funds are there for those “uh-oh” moments, when your hot water heater conks out or you get hit with a major dental bill.
Starting an emergency fund while also having sinking funds can be a good idea. When you have both, you have money set aside to pay foreseen and unforeseen expenses. And just like sinking funds, one of the benefits of having an emergency fund is that you’re less reliant on high-interest credit cards to pay for things.
Sinking Fund vs Savings Account
Sinking funds and savings accounts can refer to the same thing. For example, you might hold your sinking funds in a high-yield savings account at an online bank. But it’s also possible that you have other savings accounts that are not specifically used for sinking funds. Sinking funds usually have a specific goal, which can help you get money motivated.
Saving funds can be more general. If you have kids, you might set up savings accounts for them to teach them the value of money. Or you might have a savings account that you treat as a slush fund, where you keep money that you haven’t earmarked toward any specific goal.
If you have both sinking funds and savings accounts, it’s important to track what money goes where. That way, you can ensure that you’re saving enough in your sinking funds and not shortchanging any of your planned expenses.
Alternatives to Sinking Funds
If the idea of sinking funds seems too complicated or you don’t think that you need them, there are other ways to save for planned expenses. Here are some alternatives to sinking funds you might consider:
• CD ladder. A CD ladder involves opening multiple CDs with varying, staggered terms. Because these are organized to have a CD coming due on a regular basis, they can offer a reassuring degree of financial liquidity, or access to your money. You can also earn interest on deposits.
• Save extra paychecks. If you get paid biweekly, you probably know that some months have three pay periods instead of two. Rather than spending the extra paycheck, you could tuck that money aside, saving or paying for a planned expense.
• Use windfalls. If you’re on the receiving end of tax refunds, pay raises, rebates, or cash gifts, maybe you don’t want to go on a shopping spree. Instead, you could treat that as “extra” money and use it to pay for planned expenses or save for other goals.
Some people let their emergency fund do double duty as a sinking fund. But again, whether it makes sense to have a separate cash cushion vs. emergency fund can depend on the type of expenses you’re saving for and how much you’re able to save. For many, having a clear separation between money for unexpected expenses and money saved for foreseeable goals can be a very positive arrangement.
Banking With SoFi
A sinking fund can help you stay on track when saving for planned expenses. You can use sinking funds to save for a wide range of expenses, without having to dip into other savings, your emergency fund, or breaking out your plastic. It can be a helpful way to organize your finances and meet your money and lifestyle goals.
If you’re ready to start saving, consider opening an online bank account with SoFi. We offer Checking and Savings online, in one convenient place. When you sign up with direct deposit, you’ll avoid all the usual banking fees while earning a competitive APY on deposits as you work toward your financial goals.
What is the purpose of a sinking fund?
The purpose of a sinking fund is to help you save money toward planned expenses. You may use sinking funds to save for either one-time or recurring expenses.
How is a sinking fund different from an emergency fund?
A sinking fund is designed to pay for planned expenses. Emergency funds are used to hold money for unplanned or unexpected expenses.
What is considered a healthy sinking fund?
A healthy sinking fund has enough money to cover any planned expenses you might have on the horizon. The size of your sinking fund will depend on which expenses you’re planning for, how often you’re saving for those expenses, and how much you’re saving toward them each month.
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