Are you tired of being caught off guard by unexpected expenses or relying on credit cards for large purchases? What if there was a way to plan ahead and save money specifically for those expenses? Enter the sinking fund—a powerful tool used by businesses and individuals to set money aside for future expenses. In this article, we’ll explore what a sinking fund is, the different types of sinking fund accounts, the pros and cons of using sinking funds, and how to set one up.
What is a Sinking Fund?
A sinking fund is a dedicated savings account for a specific expense that you know is coming. Unlike a regular savings or emergency fund, which are designed to cover unexpected expenses, a sinking fund allows you to plan for known expenses and save a certain amount each month to meet your financial goals.
Let’s say you want to take a vacation in a year that will cost around $1,200. Instead of relying on credit cards or depleting your emergency fund, you can set up a sinking fund. By saving $100 each month for a year, you’ll have the $1,200 needed for your vacation, without straining your budget.
Types of Sinking Fund Accounts
If the sinking fund strategy appeals to you, it’s time to decide what type of account to open. Here are some examples of savings accounts that can be used as sinking funds:
Checking Account
A free checking account can be a good option for a sinking fund. You have easy access to your funds when needed. If you’re saving for a single large purchase, you can use a secondary checking account solely for that purpose. Look for checking accounts with higher interest rates to maximize your savings.
Traditional Savings Account
A regular savings account is another option for your sinking fund. You can open a new savings account through your existing bank or credit union, making it convenient to transfer funds as needed. However, traditional savings accounts often have lower interest rates, so you may not earn as much on your savings.
High-Yield Savings Account (HYSA)
An HYSA offers a higher annual percentage yield (APY) than a regular savings account, which means you’ll earn more interest on your savings. Setting up an HYSA as a sinking fund can help you achieve your financial goals faster. Online banks typically offer the best HYSA rates due to lower overhead costs compared to brick-and-mortar banks.
Sinking Funds: Pros & Cons
As with any financial strategy, sinking funds have their advantages and disadvantages. Let’s explore the pros and cons:
Pros
- Planning for irregular expenses: A sinking fund allows you to save for irregular expenses, such as insurance premiums or car repairs.
- Saving for large purchases over time: By spreading out the cost of a large purchase over time, you can avoid going into debt.
- Avoiding using credit cards or loans: With a sinking fund, you won’t have to rely on credit cards or loans to pay for planned expenses.
- Earning interest on your savings: Saving money in a traditional or high-yield savings account allows you to earn a return on your savings.
- Avoiding impulse purchases: Sinking funds help you prioritize your expenses and avoid unnecessary purchases.
Cons
- Slow progress: Saving for a large expense can take time, and it’s easy to feel discouraged if it takes longer than expected to reach your goal.
- Budgeting challenges: If you don’t have enough disposable income to contribute to your sinking fund, it can put a strain on your budget and lead to financial difficulties.
- Potential overwhelm: Managing multiple sinking funds can become overwhelming when trying to keep track of everything.
While unexpected expenses can throw off your budget, sinking funds provide a strategic approach to saving for specific future expenses. Consider using budgeting apps like Monarch Money or Simplifi by Quicken to stay on top of your monthly expenses, including your sinking fund.
How to Create a Sinking Fund
Setting up a sinking fund is relatively simple once you decide to give it a go. Follow these steps to get started:
Step 1: Decide what you will save for.
Determine why you’re saving. Are you planning a family vacation, looking to replace an appliance, or want to avoid a hefty car loan? A sinking fund can be used for various expenses.
Step 2: Set a monetary goal.
Determine the cost of the expense you’re saving for. If you need to purchase a new fridge worth $1,000, that becomes your sinking fund goal.
Step 3: Determine a timeline.
Decide when you want to have the money for the expense. If you want to buy the fridge in 5 months, you’ll need to save $200 per month to reach your goal.
Step 4: Choose where you’ll save the money.
Consider opening a high-yield savings account, where you’ll have easy access to your funds while earning a higher interest rate. Alternatively, you can use a traditional savings or checking account and track the amount earmarked for your sinking fund.
Step 5: Rework your budget.
Review your budget to ensure you can comfortably contribute to your sinking fund. Adjust your expenses and explore areas where you can cut back to make room for your monthly contributions. Tools like Quicken can help track your spending and identify areas to save.
How Many Sinking Funds Should I Have?
The number of sinking funds you should have depends on your budget and savings goals. While there’s no ideal number, having too many sinking funds can complicate your budget. Consider checking with your financial institution to see if they offer savings accounts with customized buckets. This way, you can have one account to manage while still saving strategically for various future expenses.
Sinking Fund vs. Savings Account
A sinking fund is a type of savings account but used differently from a traditional one. With a regular savings account, you contribute money regularly, which builds until you need to spend it. In contrast, a sinking fund involves identifying a specific savings goal, determining the required amount, and regularly setting aside money until you reach the goal. Once achieved, you can use the funds for the designated expense.
Sinking Fund vs. Emergency Fund
Emergency funds are another type of savings account, designed to cover unexpected expenses. Finance experts recommend saving between 3 and 6 months’ worth of expenses in an emergency fund. While both sinking funds and emergency funds are useful, having a sinking fund for planned expenses helps preserve your emergency fund’s integrity and avoids unnecessary debt.
Are Sinking Funds Right for You?
If you have a future expense and need to find the money to pay for it, a sinking fund is an excellent choice. Instead of tapping into your emergency fund or relying on credit cards, you strategically save money over time. Sinking funds come with little to no risk, as you use regular savings accounts to plan for upcoming expenses.
Where to Keep Sinking Funds
For optimal results, consider keeping your sinking funds in a high-yield savings account. An HYSA provides easy access to your money and offers higher interest rates compared to traditional savings accounts. Alternatively, you can use a traditional savings or checking account or designate money within your existing savings account for specific expenses.
Frequently Asked Questions (FAQs)
If you still have questions about sinking funds and how they work, here are some commonly asked questions:
Can sinking funds be withdrawn?
Most sinking funds are kept in checking or savings accounts, making them easily accessible when needed.
Is a sinking fund risky?
Sinking funds are a low-risk savings strategy. Unlike investments that carry the risk of loss, sinking funds utilize regular savings accounts.
Can sinking funds be used for repairs?
Yes, sinking funds can be used for any expected future expenses. For example, you can save for planned repairs or renovations using a sinking fund. However, unexpected repairs may require tapping into your emergency fund.
And there you have it—the secret to effective money management and achieving your financial goals. Consider implementing sinking funds into your savings strategy and watch your savings grow over time. For more finance tips and advice, visit Personal Finances Blog—your go-to resource for all things personal finance. Happy saving!