If you’re new-ish to the world of budgeting you might have heard this strange term sinking fund before and wondered what it means. Nope, it’s not a new type of investment, instead, it’s an incredibly helpful budgeting tool you should definitely be using! Technically (according to Google dictionary, anyway), a sinking fund is a fund formed by periodically setting aside money for the gradual repayment of a debt or replacement of a wasting asset.
Okay, so that might not have exactly cleared up your confusion, but that’s okay, you’re in the right place! This is your ultimate guide to sinking funds so we are going to cover everything you need to know: what they are, how to use them, why you should use them, where you should keep them and even specific examples of sinking funds you should probably be using!
When you’re working to find your rhythm with budgeting it can be frustrating when big expenses repeatedly pop up and throw you off your game! Whether or not they’re a surprise like a sick pet or something you know is around the corner, like Mother’s Day, these events can really throw a wrench in your budget, but never fear…a sinking fund is here to help!
WHAT IS A SINKING FUND
Aside from the technical definition, a sinking fund is a pool of money you save by putting a small amount aside over a period of time towards a specific goal. This allows you to prepare months and even years ahead of time for expenses so they won’t wreck your budget!
HOW DO YOU KNOW HOW MUCH TO PUT IN A SINKING FUND?
To determine how much to save in your sinking fund take the total expense that you are saving for and divide by the number of paychecks that occur in the time you have to save. Let me explain…
If you want to pay your auto insurance, which costs $1200, in full next year and it is a full year away you can either divide $1,200 by 12 months and determine that you should save $100 each month in a sinking fund, which would yield you the full $1,200 in a years time. You would then add this extra $100 as a line item in your monthly budget, and adjust your budget accordingly! If you set up a new budget for each paycheck and you’re paid bi-weekly then you would divide $1,200 by 26 (pay periods) and you would then need to budget $46.15 each paycheck.
HOW IS A SINKING FUND DIFFERENT FROM AN EMERGENCY FUND?
Sinking funds and emergency funds are terms that many people use interchangeably but they are different concepts. A sinking fund, as defined above, is more focused on specific expenses that you know will occur, at some point in the future. whereas an emergency fund is a pool of money that sits waiting to cover expenses you might not necessarily be anticipating such as a medical emergency, loss of income, etc. In addition, an emergency fund is usually a larger amount of money, often recommended to equal the amount of 3-6 months of living expenses to omit stress over finances in the event of these sometimes life-changing events.
ARE SINKING FUNDS AND CASH ENVELOPES THE SAME THING?
While these concepts are also very similar, there can be some differences. When using the cash envelope system, you are withdrawing physical cash from the bank, putting it in an envelope and using it for purchases that fall under a specific category. These are usually shorter-term purchases that will often occur within each pay period. For example, we have a food cash envelope because we go grocery shopping on a weekly basis so it makes more sense to take the cash out and fill up our “food” envelope each paycheck.
Starting a sinking fund for food wouldn’t make much sense because you would be saving money and possibly transferring it to a separate account only to withdraw it each time you went to purchase food.
Oftentimes, you can keep a sinking fund in a cash envelope, especially if it’s a shorter term. If you only begin a Christmas sinking fund in October and you’d also like to begin shopping for Christmas at the same time, it might make more sense to keep that sinking fund in a cash envelope instead of a bank for easier access.
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WHERE SHOULD YOU KEEP YOUR SINKING FUNDS?
This is a personal decision based on the specific expense and what feels more convenient and comfortable for you! Personally, I try to keep minimal cash in my home and on my person at all times as that’s what feels more comfortable to me. If you need this sinking fund to be very liquid and it’s a relatively smaller amount of money you may opt to keep it in a cash envelope in your home (if you have a safe that’s a great place to store your cash envelope).
This choice will also be dependent on how long you plan on having the sinking fund and how much you will be saving. For example, If you’re starting a sinking fund to purchase a car within the next year than a bank would be a better choice. Personally, we prefer high yield savings accounts at an online bank over our local bank.
We’ve had a Capital One 360 account for well over 10 years now and have been very happy with it! You can get $25 when you open a Capital One 360 savings account. While the interest fluctuates, you will always earn a substantially higher rate at an online bank over your local brick and mortar bank!
We also recently opened up an online account at Ally Bank and have been very happy with them as well! Using online banks allow us to:
- Keep our money fairly liquid. It takes around 3 business days to transfer money to our local bank if needed.
- Earn interest while our money sits waiting for us to use. No, you won’t become a millionaire overnight but you will earn some money while it’s parked there growing!
- Remove temptation. Since you do have to transfer money and wait a few days, it does offer a built-in buffer to help keep you keep from using that money for other purposes not originally intended!
You can set up a separate account for each sinking fund or you can keep them all together in one account and track them on your own. I use a sinking fund tracker from my budget bundle. This is just a tracker where I record any debits/credits and the balance for each sinking fund so I can easily see at a glance where each fund stands without having to login into my accounts.
EXAMPLES OF SINKING FUNDS
While you can have a sinking fund for anything, I want to highlight three examples of sinking funds that will have the biggest impact on your finances. Remember, there aren’t any set rules when it comes to sinking funds, they are simply a tool to help you save for a specific expense!
START A CHRISTMAS SINKING FUND
One of the best sinking funds to have is a Christmas fund (if you celebrate). Christmas comes every single year – same day same time – so there’s no avoiding it yet somehow each year many people find themselves having to use a credit card to purchase gifts and spend the beginning of each new year trying to pay off the bills they created over the Christmas season.
How would it feel when Christmas came next year and you have $1,000 sitting in an account waiting for you to use to purchase gifts?!?! Amazing, right? Wouldn’t that greatly decrease your stress around the holidays? Yep! Wouldn’t that allow you to better enjoy the holiday season?! Sure would!
Sure, I get that $1,000 might not be enough to cover all your holiday expenses, but it would sure be a great start!
The key is to start planning now! Sit down and look at alllllll the expenses you incur during the holiday season (join my resource library and download a FREE holiday budget planner) and determine how much you think you will need. Then, as we did above, divide that amount by the number of paychecks or months you will be saving for. If that gives you an unrealistic amount to save each month for your budget, go ahead and choose an amount you know you will be able to save each month/paycheck and start there. Again, some savings in a sinking fund come Christmastime is better than none!
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START A NEW CAR SINKING FUND
And by “new” I mean “new to you” 🙂 Don’t waste your money purchasing a brand new car as you’ll lose a huge amount from depreciation the first two years of driving it. Once we finish saving our emergency fund, we will begin contributing to our new car sinking fund!
Currently, we drive two paid off cars. It’s amazing not having a car payment, but we know the day will eventually come when we will need to replace one (or both) of them and we want to be prepared! Our plan is to purchase a used car for cash, which means we will need to save a good chunk of change!
We plan on adding $100 each month to our new car sinking fund plus any extra we have at the end of the month!
When the time comes to go car shopping we will have a clear budget and feel confident asking for a cash discount. Using a sinking fund to save and plan for this huge purchase means we won’t have to go back into debt to buy a new car that is reliable and safe for our family!
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START A VACATION SINKING FUND
Many people choose to forego vacations while paying off debt, but the reality is that no matter your current financial situation most vacations come with a decent price tag! Sure, there are many ways to save money when traveling and it’s totally possible to vacation on a budget no matter the cost, a vacation sinking fund will ensure you’re not feeling any financial stress during your tips!
You can do this one of two ways: if you’re taking a trip that you know the total cost, use the calculation we discussed above to set up your savings amount.
If you don’t know a specific amount download your free travel budget planner from my Resource Library and estimate your costs. This will help you account for all of your vacation expenses and give you a great place to start!
OTHER BENEFITS OF SINKING FUNDS
If I haven’t yet convinced you how wonderful sinking funds are, I want to share my very favorite thing about them…I’ve found that the act of building and using sinking funds for specific purchases actually removes the feelings of guilt often associated with spending larger amounts of money.
Let me explain – prior to us improving the way we handled our finances, I would have massive feelings of guild around the holidays. We have a lot of people to buy for and so we spend a decent amount of money on Christmas gifts. Dropping $2k+ in two months while Christmas shopping always made me feel like I was over-spending or wasting money (I wasn’t, actually, but I still felt that way).
Now, making a specific holiday budget and saving money in a Christmas sinking fund will completely alleviate those feeling since I know my spending is planned for, saved for, and completely intentional! I won’t be over-spending…I will simply be sticking the plan!
Similarly, one might feel overwhelmed and have buyer’s remorse after spending thousands of dollar to purchase a vehicle! But when you’ve taken a good look at your finances, set a budget and saved money in a new car sinking fund, it takes the negative emotions out of the purchase!
Take some time, review your budget and see where sinking funds might make sense and help you reach your financial goals. Don’t forget to check out all the budgeting products in my shop to help you organize your finances and budget your best life!