How to Create a Sinking Fund
Sinking fund. Yes, the name sounds negative, but the financial move is anything but negative. It is a very wise planning decision. To put a simple definition to it—a sinking fund is a fund set up for a specific purpose to which a person regularly contributes.
Let’s break down that definition. “A sinking fund is a fund set up for a specific purpose.” There are larger, known expenses for you need to save. As an example, you will probably need to purchase another car at some point in the future. This is a larger, known, future expense. Therefore, you could have a sinking fund for your next car purchase. Other examples of large, known expenses may also include vacations, taxes, or private school tuition. Again, all of these are larger, known, future expenses.
To be clear, a sinking fund is not an emergency fund. An emergency fund is meant for those large, unforeseen expenses. They are financial emergencies. Large medical bills are common unforeseen expenses. You should not use emergency fund dollars for vacations, taxes, or normal automobile replacement. Sinking funds are for a specific purpose that you identify.
Continuing with the definition—“…to which a person regularly contributes.” The word “sinking” communicates the gradual nature of these funds. These funds are gradually built over time. It is common to build a sinking fund one monthly transfer at a time. Individual and couples regularly set up automatic transfers from their checking to a savings account that has been designated for one or several sinking funds. Over a period of time, they are able to save enough for their vacation, car, or whatever expense they’ve identified.
Here's an example of how to set up a sinking fund:
Let’s assume you plan to purchase a car in four years. You determine the amount you need to save for the car is $24,000. Assuming you prefer to make monthly contributions to your car sinking fund, you must divide $24,000 by 48 months (four years).
$24,000 / 48 = $500 per month.
Therefore, you need to set aside $500 per month in a sinking fund to hit your savings goal.
For another example, let’s assume you want to spend $3,000 on a vacation every year. To reach this goal, you must set aside $250 every month.
$3,000 / 12 months (1 year) = $250 per month.
The amounts you plan to set aside every month should be considered as you craft your monthly budget. For many, this means reducing expenditures in other areas. However, the momentary sacrifice is worth it. You can avoid debt for these expenses, which increases the cost of the expense.
What type of accounts are best for sinking funds?
Savings accounts are typically the best place for sinking funds. The type of savings account is dependent on the minimum balance requirement. High yield savings accounts can be a good option if the minimum balance requirement can be maintained. If not, a basic savings account will work.
Why wouldn’t I use an investment account?
Investments should be used for longer term goals, like college tuition and retirement. The longer time horizon allows you to better weather the market’s ups and downs. Sinking funds are used for relatively shorter-term savings goals. You would not want to approach year four of our car example and have a 30% drop in your underlying investment. Nor would your family want this to happen to the vacation example. “Sorry kids. We can’t go to the beach. Blockbuster didn’t do as well as I thought this year.” So, keep your sinking funds in savings accounts.
Should I keep all my sinking funds in one savings account?
This is up to you. Your savings account likely has a minimum balance requirement. Keeping multiple sinking funds in a single account can help ensure the balance requirement is met. If you decide to keep multiple funds in a single account, remember to keep track of the different funds. A basic Excel sheet can help you keep track of what has been saved and spent within each savings account.
Sinking funds are a great strategy to implement in almost any budget. Consider what larger, known expenses you have in the future and build out your sinking funds.