The concept of a “sinking fund” might be as foreign to you as it was to me when I came across it a while ago. Just looking up the definition can be confusing since there are at least two uses for the term:
- A strategy for the repayment of a specific debt over a period of time
- A strategy for funding a known future expense
- Historically, the term originated in Great Britain as a game plan for paying off national debt.
- It was also used heavily in the railroad industry here in the U.S.
- Investment companies define it as a type of staggered repayment that adds safety to corporate bonds.
- In the business world, a sinking fund might be created for the expected replacement or repair of assets such as equipment and buildings.
For you and me, the most practical application of a “sinking fund” is to set aside a monthly amount to fund a future expense.
Some financial advisors swear by using sinking funds for everything and anything — from trivial holiday spending to important purchases like a new vehicle or home. Some even use them to create a budget that’s more predictable (for instance, creating one big sinking fund that averages all your utility payments so you ‘pay’ the same amount each month, regardless of billing fluctuations).
Thinking Backwards, Planning Ahead, Waiting in the Middle
The purposes of sinking funds may be diverse, but they all require thinking backwards. Taking the amount of the purchase you want/need, and dividing it by the number of months you have to work with. For instance, if you know you want to spend $600 on Christmas gifts this year, and it’s July, you’ll need to set aside $100 from now until December.
Sinking funds also require planning ahead. In the previous example, saving $100 a month starting in July might mean digging for change in the car seats, but if you had started in January, it would be a more comfortable $50 a month. The further ahead you anticipate large bills and purchases, the less painful it will be to create the sinking funds for them (a great way to remind yourself is a dedicated financial calendar).
Patience, grasshopper. Children are taught patience by setting aside money in a piggy bank where they can’t touch the money until it’s ‘time.’ Think of a sinking fund as a piggy bank you get to smash when the time is up. How gratifying will that be?
Where to Stash It
Since sinking funds are mostly used for shorter-term savings, you shouldn’t need to deliberate over which investment account has the best interest rate or the right risk factor. If it’s a small amount (say, a $100 graduation gift for a senior), you can just stash it in that piggy bank, under your mattress — wherever no one will touch it. If it’s a larger amount that won’t be cashed out for a while, it might be safer in the bank. While it’s there, you might as well take advantage of higher-yield savings account that will earn a few extra dollars beyond your goal. Still, the main focus of a sinking fund is consistency in your deposits, not the rate of return.
The sinking fund isn’t a new concept, but maybe it’s as new to you as it was to me. Really, it’s just a smarter way to save for specific expenses and purchases by thinking backward, planning ahead, and having the patience to wait in the middle.
Have you ever used a sinking fund? Did it work well for you?