What Is A Sinking Fund?
Everybody has financial goals. Whether it’s buying a new car, putting the kids through college, or going on a lavish vacation, you need to set aside part of each paycheck with diligence if you want to reap the fruits of your labor.
But if you already have retirement funds, general savings, an emergency fund, and other investments, how do you save for these other goals?
Introducing the sinking fund.
Why Should You Have A Sinking Fund?
Essentially, sinking funds are dedicated savings accounts for specific goals. There are a ton of goals you can use a sinking fund for.
Because of this, you may want separate sinking funds for each goal you have. Doing so helps you separate your money and focus on each individual goal.
Common sinking fund expenses include
- Down payments
- Taxes (especially for those who pay quarterly)
- Prescription items like glasses or contacts
So how do you work these sinking funds into your budget?
Easy: estimate how much you’ll need in your sinking fund and divide that estimate by the amount of months (or paychecks) away that goal is. You’ll know exactly how much you need to put aside from each month or paycheck to reach your goal.
In addition, you can then check your sinking fund goals against your budget to make sure you can sustain all these goals on top of your normal spending.
Simple enough, right?
Well, planning the amount you’ll need to save is where things can get tricky.
Some expenses like a down payment are easy to save for. In the case of a down payment, you’ll know exactly how much you need to put down to purchase the home, making for an easy time identifying the amount you need to save.
But many expenses don’t have definite amounts.
For example, car repairs are to be expected regardless of your driving habits. However, repair shops can differ wildly in price for routine repairs, so you won’t be able to plan for an exact amount.
In this case, you’ll need to do some more leg work.
To save for unsure amounts, do some research into what that expense typically totals to. Look back at your spending history on the expense in question for further insight.
Then, use the data you’ve gathered to determine an amount and save a little bit more than that amount for cushion. Stop saving when you’ve accumulated enough.
When you spend out of this sinking fund, replenish it as needed.
This approach has a bit of an “emergency fund” slant to it, but it retains the focus on specific expenses instead.
What Type of Account Should I Put My Sinking Fund In?
Generally, high-interest accounts of any kind will work great for sinking funds as your interest can either speed up your savings goal or add some extra cushion in case circumstances change.
However, the optimal sinking fund account varies based on your timeline and the uncertainty of the expense.
If you need to save for something more short-term, a high-interest money market account will serve you well. They earn great interest rates, while still retaining enough liquidity to access your money when you reach your goal.
Similarly, a high-interest savings account is a good choice. Savings accounts are different than money market accounts, but for the purpose of building a sinking fund, the benefits are the same (barring differences in interest rates).
Either way, the liquidity of these types of accounts relative to longer-term investments makes these accounts excellent for more uncertain expenses like home remodeling or car repairs.
As for longer-term goals…
Let’s say you’re saving for a large goal several years in the future, such as a house down payment. You won’t need to access the money for a long time and you usually know how much you need to put down on a house, making the relatively illiquid bank CD an excellent investment vehicle.
In exchange for locking away your money, you earn interest rates that blow high-interest savings accounts out of the water.
Such interest rates can be of great help when you need to save $40,000 to put down on a house. Also, the illiquidity greatly reduces temptation to dip into your sinking fund irresponsibly.
If you’re saving for multiple goals at once, you’ll want to separate each one into a different account for tracking purposes.
What about stocks, you ask?
True, the stock market is quite liquid and the potential returns tend to be greater than most bank products.
But the stock market is not a good place to store your sinking fund, as it’s more volatile and doesn’t come with the same FDIC insurance that you bank account has.
When you’re saving for specific financial goals, you should prioritize safer investments over slightly higher returns. You should be relying on your own savings to fill your sinking fund, not the returns.
Not to mention that to access your sinking fund, you’ll need to sell off stock. This can lead to a bunch of tax consequences that render your savings efforts less effective.
Sinking Funds vs. Emergency Funds Vs. Your Savings
On the surface, sinking funds look like a rebranded version of emergency funds. In addition, they don’t seem that much different from your normal savings.
But each type of fund is designed for a different purpose.
Sinking Funds vs. Emergency Funds
An emergency fund is one of the first financial assets you need to build before you start building wealth.
Instead of serving as a means to build wealth, your emergency fund serves as a last resort against unexpected, dire situations like job loss or hospitalization. Without it, you’d have to put yourself in a ton of debt or seek out other solutions that aren’t much better.
Common recommendations say to save at least 3 months of living expenses in your emergency fund. To be safe, you should strive for up to 6, especially if you have dependents such as family.
Your best bet when building your emergency fund is to open a high-interest savings account. That way, your money will earn an appreciable amount of money while it’s dormant.
Once you’ve built up a proper emergency fund, you aren’t supposed to touch it until you find yourself in dire straits. You shouldn’t contribute more to it either unless you use it for an emergency, as it’s not meant to be a spending account and your money could be better invested somewhere else.
On the other hand, sinking funds are designed for savings for specific, planned (or foreseeable) expenses. For example, you might use a sinking fund to save for your next vacation. That’s a planned expense.
Or perhaps your phone is getting old and you’ll eventually need a new one. You don’t know exactly when, but you know it’ll happen someday.
But if you dropped your phone and it broke on the sidewalk, you’d dip into your emergency fund as that’s more of an unexpected expense.
Not to mention not having a phone in today’s society nearly constitutes an emergency.
Sinking Funds vs. Your Savings
A general savings account is used to build wealth. When you end up with extra cash and nothing to spend it on, your best bet is to put it into your savings.
Eventually, you’ll have enough money to where your money works for you by earning significant interest.
Because of this, you don’t want to touch your normal savings at all, lest you slow down your wealth-building efforts.
But sinking funds aren’t designed to build your net worth; they do allow you to make purchases that would otherwise put you into debt. Therefore, they can help you maintain your net worth while still enjoying life’s big purchases and reaching your financial goals.
Of course, in the best case scenario, an asset you buy with your sinking fund could increase in value or earn you additional income as a nifty byproduct.
Sink Your Teeth Into Your Goals
Saving for big-time financial goals is intimidating, especially when you’re already trying to juggle paying the bills and building your wealth.
But if you take advantage of sinking funds, you can budget for large purchases without a lot of extra headache.
Depending on your goals, you could be running multiple sinking funds at varying interest rates. If you have no other need for the interest income, hey, it’s free money! Spend it as you wish, although we recommend investing it to build your wealth that much more.
If you’ve got a financial goal you’re working towards, open an account suitable to the nature and timeline of your goal and start saving! For best results, set up an automatic transfer so you don’t even have to think about the money you’re stowing away.