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Budgeting for those countless unique or big purchases can be rough, and after my many failed attempts, I heard about a sinking fund, a type of account that you use to set aside money to save for something in the future. I immediately began using a sinking fund for items such as birthday gifts or new tires for my car, and eventually began using it to automatically save for just about everything.
Not only has a sinking fund helped me stop blowing through my budget each month, but it’s also helped me become more thoughtful and proactive with how I spend and save my money.
Sinking fund definition
A sinking fund lets you set aside a little bit of money each month to help prepare you for a planned expense. You can save this money for a specific item or split it between different categories to then be used at a later date.
The important thing to know is that these funds are intentionally used for clear-cut expenses and not for routine monthly bills or that new pair of shoes you’ve been eyeing (bummer, I know). Sinking funds should be used for things like holiday gifts, travel, a new car, or an irregular bill such as an expensive vet visit or a broken washing machine.
You can even set a line item in your monthly budget explicitly for your sinking fund. This way, you transfer a little bit of money into that sinking account monthly, and you won’t be scrambling to find extra money for those bigger purchases when the time comes. You’ll be more than prepared.
What is the purpose of a sinking fund?
Even if you’re diligent about sticking to your monthly budget, life happens, and unexpected expenses pop up throughout the year.
This can leave you reaching for your credit card especially around the holidays, and no one wants to start off the New Year on the wrong foot. According to a 2020 survey, the average American will spend a little less than $1,000 on holiday shopping.
But what if you were able to set aside $50, $75, or $100 each month to save for these gifts? You’re now suddenly much more in control of your spending and not risking your financial health to buy presents.
Aside from helping you prepare for things like excess holiday spending, a sinking fund can help you dream big when it comes to your money goals. Want to buy a new car and pay cash? Want to take your family on a special summer vacation? The purpose of a sinking fund is to help you do these things and feel good about it!
Benefits of a sinking fund
Here are some of the advantages of starting a sinking fund and why it might move to the top of your to-do list:
- Say goodbye to high interest rates: You can avoid getting a loan for some bigger purchases if you have a sinking fund to use, which means paying no interest! A lot of loans have high rates, and interest could end up costing you a lot of money, not leaving much room to save. This means less cash for you to use to cover other one-time expenses.
- Dodge impulse purchases: A sinking fund can also be useful in limiting those expensive impulse purchases that can take a long time to pay off. For example, if your washing machine breaks and you need a new one, you will be more likely to stick to the budget in your sinking fund, rather than buy the most expensive one at the store because it looks super fancy.
- Pay off debt faster: A sinking fund will allow you to make extra debt payments since you will already have money put aside for sudden expenses. Usually you have to dip into your savings or disrupt your monthly budget to cover these costs, but a sinking fund will take care of it and let you stay consistent with your routine payments toward your debt.
- Spend your money guilt-free: Working on your sinking fund makes you more prepared and lets you spend your extra money without the guilt of knowing it should be used elsewhere. When it comes time to spend, you can do so without any worry or regret!
Sinking fund examples
How does a sinking fund actually work? Of course, you can personalize your sinking fund categories to fit exactly what you need, but here are some examples.
Let’s say you have 3 things that you’ve decided to save for with a sinking fund: car insurance, holiday gifts, and summer vacation.
For each expense, list out how much it will cost and when you’ll need the money:
- Car insurance: $600 bill, due in 6 months
- Holiday gifts: $750, saved in 3 months
- Summer vacation: $1,200, saved in 10 months
Next, break each expense into the monthly amount you need to save:
- Car insurance: $100 per month
- Holiday gifts: $250 per month
- Summer vacation: $120 per month
Once you have that calculated, include those expenses in your monthly budget and set up a monthly automatic transfer to your sinking fund.
Sinking fund formula
There are also sinking fund formulas you can use and incorporate into your budget to help calculate the exact amount of money you need to save each month. A sinking fund formula works alongside an Excel spreadsheet, a mobile app, or even a tangible notebook to write and track these numbers.
Although the formula looks a little intimidating at first glance, once you use it a couple of times, it will become second nature and help you build your sinking fund over time.
Let’s look at the most commonly used formula:
Sinking Fund, A= [(1+(r/m))n*m-1] / (r/m) * P, where:
- P = Periodic contribution to the sinking fund
- r = Annualized rate of interest
- n = No. of years
- m = No. of payments per year
Now, this may look confusing, but following these steps will make the process easier and less discouraging, ensuring you will follow through with the savings goals you’ve set for yourself.
Sinking fund alternatives
So now you understand the purpose of a sinking fund. But, what’s the difference between a sinking fund, an emergency fund, and a savings account? Check this out:
Sinking fund vs. emergency fund
If you put money into an emergency fund, you might wonder if that’s really different than setting aside money in a sinking fund account. Yes, it is! Money in an emergency fund is to be used for emergencies only — like your car breaking down or losing your job. It’s a bad habit to withdraw money from your emergency fund for non-emergencies. When a real emergency strikes, you’ll be happy to have that cash available. Money in a sinking fund is used for known expenses like car insurance, vacations, or holiday gifts. You can spend that money without the headache because you’ve planned and saved for it.
Sinking fund vs. savings account
A valid question is, “Why can’t I just use the money in my savings account for all of these sudden expenses?” Basically, a sinking fund is a more deliberate tool compared to a savings account. You have specific goals for total funds and use. It’s also a good idea to keep these accounts separate so the lines don’t start to blur.If you’re saving for next year’s vacation, your kid’s birthday gifts, and your retirement all in the same place, it could get confusing fast. Being intentional and putting the funds into a separate sinking fund can keep your money organized. Want to set up a savings account first? Use a high-yield savings account to get the best bang for your buck!
How to start a sinking fund
Now that you know what a sinking fund is and how it can help your financial goals and well-being, you’re almost ready to go! It’s easy to start your own sinking fund. Here are the steps you’ll want to take:
- Open an account specifically for your sinking fund. You’ll want to keep this money separate from your other accounts so you know exactly how much you have available to spend.
- Make a list of all the things you want and need to save for, as well as how much they cost. Think about things you have to pay for (taxes, insurance) and the things you’re excited to spend money on (vacations, a new car, holiday spending).
- For each item, figure out the date when you’ll need the money.
- Calculate how much you need to save each month to have the total saved by the time you need it.
- Set up monthly automatic transfers to move money into your sinking fund account. And yes, you really do need to make these transfers automatic.
How much money should be in my sinking fund?
This is a great question, and although it may not be the exact answer you are looking for, it depends on your personal needs or financial goals. One person may dedicate their sinking fund to wedding expenses while you decide you want to start one to buy your mom an awesome birthday gift. The amounts needed for these items are probably going to look a little different (unless you plan on buying your mom a new Mercedes). A good place to start is to evaluate what expenses in your life typically disrupt your monthly budget and figure out how much you need to put away each month to meet that amount.
Where do I keep my sinking fund?
You want to make sure your sinking fund is completely separate from your spending and savings accounts. It’s also a good idea to not keep it attached to your emergency fund. If this means you have to open up another account, that’s ok! Staying away from your everyday accounts will make your sinking fund less accessible, and you will be less tempted to touch those funds for unnecessary items and be reluctant to play into overspending habits.
What should I work on first: my savings account, emergency account, or sinking fund?
It’s always good practice to work on building your emergency fund first since when a crisis hits, that will be the most helpful pot of money. However, your savings account could be equally as important, depending on your financial health. A sinking fund is a great account to save and set money aside for, but it’s wise to take a step back and evaluate your priorities when it comes to your finances and set up a plan for success!
If you find yourself constantly unprepared when irregular expenses arise and reaching for your credit card, it’s time to start thinking about building a sinking fund.
While it’s a little extra work up front to set up your transfers, it’s worth it in the long run. To start your sinking fund, check out the Chime app which makes managing your money way easier on mobile. You can also use the automatic savings feature to reach your sinking fund goals even faster.
Now that you know how to get started, it’s time for the fun part: what are you excited to save for?