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 its national debt.
- It was also used heavily in the U.S. railroad industry here in the past.
- Investment companies define the sinking fund 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 backward – 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, then 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 to set up 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 raid. If it’s a larger amount that won’t be cashed out for a while, it might be safer in the bank. Plus, you might as well get a little bit more interest with a 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?
{ read the comments below or add one }
I’m a big fan of sinking funds. I have 34 categories in mine – from HOA dues (bi-annual), insurance or government fees like vehicle tags (annual), Christmas, birthday/anniversary gifts, car repairs, house repairs, back-to-school money, clothing, shoes, sports equipment replacement, electronics (repair or replace), appliances (repair or replace), annual memberships (zoo, shopping club, for instance), etc. It takes some work month-to-month to track it all in a spreadsheet – but that’s part of the fun! Haha 🙂 I keep it in a “high” interest savings account and earn a few bucks a month of interest, but never have to worry about how to pay for any of those things because they’re covered a little bit at a time. One small step to financial independence. It is very calming to not have to worry about those items at all.
Sinking funds work well in tandem with the “envelope” method of budgeting. A sinking fund is simply another envelope. They are great for:
1) one off purchases such as a new laptop, TV, vacation, or vehicle
2) regular, non-monthly expenses such as car insurance, taxes, registration, gifts, charitable contributions
3) variable monthly expenses such as water/gas/electric utilities, allowing you to smooth out the costs over time
4) variable non-monthly expenses, such as health care costs, vehicle maintenance, home maintenance, or clothing
In reality, most one-off expenses (category 1) actually fall into categories 2, 3, or 4. While you might buy a new car and drive it for 10 years, you know it will need to be replaced eventually. So, a sinking fund for a car will actually be category 4, a variable (in $ amount) non-monthly expense. Same thing goes for refreshing electronics, appliances, vacations, or even updating the interior/exterior of your home periodically.
My wife and I plan to purchase our next vehicles with cash unless we can get some sort of great incentives for taking a non-zero interest rate loan with no pre-payment penalty. It would be easy to say that our car situation is taken care of for the next 5-10 years and enjoy living car payment free. But eventually we will have to replace our vehicles. Depending on what we end up spending on our next round of vehicles, I plan to save $400-$500 per month to cover the cost of trading into the next round of vehicles. That would allow us to spend $25K+ per vehicle every 10 years. While we might find this is not enough to get us into our next round of vehicles, it is much easier to top up our savings when we make the next purchase if we already have $50K in the bank. Separately, I plan to save for both routine and non-routine maintenance, insurance, registration, etc., on a monthly basis.
Good insight Ryan. The good news for your car is that you get to add the value of your old car when you replace it, so your fund will be more than $25k.
Isn’t this just the same as “saving up” for something in the future? Saving up for a house, saving up for a car, saving up for dental work, etc.?
Essentially it is, only that you are segregating a portion of the funds for that specific purpose.
Yes, I use a sinking fund for our car taxes. I really want to start on one and pay insurance up front to minimize the costs, but I have to take baby steps. Can’t do everything at once:)
Keep taking baby steps and before you know it, you will see huge progress when you look back.
Great job Latoya!