What is a sinking fund?
A Sinking Fund is a savings account for a specific item – generally an annual expense or planned big purchase like a vacation.
You can have multiple sinking funds
Creating additional savings accounts in your online banking is generally super easy to do.
Just make sure to change the name in your online banking of each savings account to match the item you’re saving for.
Why Sinking Funds Are Useful to You
Sinking funds are a great way to account for annual expenses or large expense in your monthly budget.
When it comes time to pay a $1,500 insurance bill, you won’t have to worry about where the money is coming from, because you will already have saved it!
View it as a loan for the future
A car is a great example of using a sinking fund. Instead of planning to get an auto loan on your next car (and paying extra interest for a depreciable asset), create a sinking fund for your next car purchase.
If you have a lot of debt, you may have a hard time contributing to this fund. Saving $10 a month seems useless. But it adds up. And you won’t be wasting money on interest on your next car.
How to use Sinking Funds
Create a savings account for a specific purpose
Name that savings account in your online banking to reflect the expense or item you are saving for.
For example, I have one for “insurance” and one for “car”, as well as a couple others.
Example of saving for insurance
Insurance premiums are usually cheaper to pay once or twice a year rather than in a monthly installment.
Break down the annual amount into 12 payments.
Save that amount each month and work it into your budget.
When insurance is due, it’s already accounted for so you won’t have to worry about where the money is coming from.
Work out the amount in your budget
If your sinking fund is for an annual expense like insurance, it’s easy to break that down and account for it in your budget.
If it’s a big purchase you know you’ll be making in a couple of years like a car – do the best you can to get a concrete number that is the total cost then divide by the number of months to the goal deadline.
For example, saving for a car
Say you want to have $15,000 saved to buy a good used car and you figure you have 5 years until you need to buy said car.
That means saving $250 a month for the next 5 years. If you’ve ever had an auto loan, you’ve already done this but with the added expense of interest.
A sinking fund is like creating an auto loan for yourself in the future without the cost of interest.
What happens if your car breaks down sooner than expected?
Hopefully, you will still have a good amount to buy a decent used car. It may not last as long, but you can automatically start saving for your next car.
Alternatively, you can still get an auto loan but at a lower amount. You’ll have a much bigger down payment if you’ve been saving anything so you will be able to get a smaller loan, and thus pay less in interest.
If at all possible, avoid getting an auto loan and just buy a car from savings. Otherwise, an auto loan will hinder your ability to save for your next car.
Categories useful for sinking funds
If you’ve never used sinking funds before, here are good first accounts to set up.
- Insurance
- New car
- Charitable Giving
- Big trip or big house project
Cautions with using sinking funds
Because it’s so easy to create savings accounts with online banking, It can be tempting to open up an account for every big expense or savings goal.
But don’t feel like you have to create a sinking fund for every large expense.
If you’ve never used sinking funds before, then just start with 1 or 2 new accounts.
At the end of the year, we empty all of our sinking funds. I learned that we had to be sure to start transferring money back into those accounts within a month or two or else our bank would close the account for being inactive.
What do you do if you save up money for a trip or project and then decide not to go through with it?
Evaluate where those dollars go. You can disperse to another sinking fund or retirement account.
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