Whether it’s a dream vacation, a new car, or a home remodel, there are so many different items and activities we save for every month. But is there a best practice to doing so?
This is where a sinking fund can play an important role. By using a sinking fund, you can prepare and budget for future costs by saving a small amount of money each month, over a dedicated period of time before you make the purchase. In doing so, you’re able to easily prepare for larger purchases that you know you’ll be encountering in the future.
The best part? By incorporating a sinking fund into your budgeting process, you’ll be able to plan for these more considerable purchases while still accomplishing your financial goals.
Keep on reading to learn more about sinking funds and how you can get started today.
What is a sinking fund and how to build one
As mentioned above, a sinking fund is a dedicated, often separate, fund or savings account, that allows you to put money aside for future planned purchases. This typically happens by saving a small amount of money each month for a specific amount of time before you make the purchase. But how exactly should you start?
The concept is quite simple. To determine how much you should be saving every month, take the total amount you plan to spend and divide it by the number of months or weeks you have left until you plan to make the purchase.
For example, let’s say you plan to book yourself a $3,000 vacation in October and it’s currently March. This leaves you with seven months to save the total amount needed, which means you’ll need to save about $430 every month until October.
Remember that a sinking fund can be used for any significant purchase or bill. As long as you’re saving up a little bit over time, you can ensure the expense won’t blindside you once it’s time to make the purchase.
The goal of using a sinking fund is to put yourself in good financial standing for planned purchases and avoid taking on unnecessary amounts of debt that can be detrimental to your financial health.
Why you need a sinking fund
To put it simply, life happens.
When you don’t have a sinking fund prepared, you may be forced to make these large purchases through another source such as your emergency fund, your savings account, or your credit card.
The purpose of a sinking fund is the ability to plan for large purchases while staying on track with your retirement income goals. You’ll be able to keep your debt low while avoiding feeling a pinch on your budget.
When you add sinking funds to your budgeting routine, you can:
- ?Save for anything you’ve dreamt of purchasing but have felt intimidated by the large, upfront costs.
- ✈️ Plan out your dreams. This can look like the vacation of a lifetime, renovating your home, or hosting your dream wedding.
- ? Spend without worry or regret. With a sinking fund, you’ll be able to lose any guilt you may have that’s associated with a large purchase.
The different types of sinking funds you should have
While there are no specific rules on what your sinking fund can be used for, almost every sinking fund can be placed into one of the following three categories:
- Large planned purchases. This is often the most common use of sinking funds and includes purchases such as a family vacation, a wedding, or a new car.
- Small planned purchases. While sinking funds are almost always put in place for larger planned purchases, they can also provide benefit for smaller planned purchases. This includes purchases such as new seasonal clothes or formal attire, or even new home decor.
- Miscellaneous and commonly overlooked expenses. This can include any yearly subscriptions, sports activities, or clothing for growing children.
By allocating your sinking funds to these three categories, you can ensure that your savings account and your emergency fund remain intact.
How is a sinking fund different from an emergency fund?
A common question that comes up when discussing sinking funds is how they differentiate from an emergency fund. If your emergency fund has already been saved, what’s the purpose of a sinking fund?
The answer is that emergency funds are reserved for just that–emergencies. Sinking funds are explicitly designed for planned expenses.
For example, if you knew that you had to replace your roof next summer, it would be classified as a known expense. Another example of a planned cost could be getting a new cell phone if you know that you upgrade your phone annually. Sinking funds allow you to plan for future expenses. This way, you can anticipate the cost, and no changes will need to be made to your other savings buckets.
However, an unexpected damage to your roof which has forced you to replace your entire roof would be covered by your emergency fund. An unexpected car repair would also be covered by your emergency fund, as you didn’t plan for someone to rear-end you at a red light. You also didn’t plan for your air conditioner to burn out on a 95°F day leading you to replace it as soon as possible.
Just remember–your sinking fund is for the known, while your emergency fund is for the unknown. And while your emergency fund can technically be within a sinking fund, it’s best practice (and recommended) that you keep these two types of funds separate.
Where should you put your sinking fund?
It’s best practice to keep your sinking funds in fairly liquid accounts–a regular savings account will work just fine. You can use one account for the total amount of savings as long as you continue to track how much money you assign to each category, or type of planned purchase. Be sure that you have check-writing account privileges as well.
You must also be aware of the fact that you shouldn’t be putting your sinking funds into the stock market. If you’re interested in earning higher interest on your money, consider placing the funds into a savings account that offers a high-interest rate.
The bottom line about sinking funds
You may be familiar with how to build an emergency fund or how to stick to your monthly budget. But adding sinking funds to your financial skillset can and will help you better manage your money so you can invest in your future and stay focused on your financial goals.
Like anything worthwhile, it will take some work, dedication, and planning to reach your goals. If you’re looking for further guidance on how to incorporate sinking funds into your savings arsenal, consider building a free financial plan with Savology today. Your plan will connect you with leading industry providers to help you accomplish your financial goals, which might just include saving up for a vacation, your wedding, or even a new car.
