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What Are Sinking Funds in Budgeting and How Do You Make One?

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You’re going to have unexpected expenses from time to time. Medical expenses, car repairs, and home repairs seem to come at the worst times. Then, there are those pesky planned expenses like annual insurance and homeowners association payments. You know they’re coming, but that doesn’t mean you’re prepared for them. 

Mix in a few big purchases from time to time and it’s easy to see why so many folks rack up so much long-term debt on their credit cards. But that doesn’t have to be you. 

After all, you know these expenses are coming, so you should be able to prepare for them. Sinking funds can help.

What Are Sinking Funds in Budgeting?

Sinking funds are savings accounts with targeted savings goals. They often come with target dates to keep you on track. 

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Sinking funds help you save small amounts of money over time to prepare for big purchases, annual holiday gifts, and other upcoming expenses. 

Many people separate their savings into sinking fund categories that each represent a specific goal. However, some banks provide sinking fund accounts that allow you to define and separate goals while saving all of the money in the same place. 

There are two types of expenses sinking funds help you save for:

  1. Target Date Expenses. Target date expenses are expenses you know are coming on a specific date. These include membership fees, insurance premiums, holiday gifts, and annual subscriptions. They can also include goals like a down payment on a new car or house to help you achieve those goals in a reasonable amount of time. 
  2. Non-Target Date Expenses. You can also use sinking funds to save for unexpected expenses that you know will come up eventually. For example, you know at some point your car and home will need repairs. You just don’t know when, exactly. Contributing small amounts to sinking funds now lessens the burden later. 

How Sinking Funds Work

Sinking funds make it easy to set aside small amounts of money over time for planned expenses and big purchases. Sure, you could throw that money in a safe, but it’s better held in a high-yield savings account or money market account that bears interest and comes with federal deposit insurance. 

Sinking funds help you cover these expenses the same way you pay off debt: through small, regular payments made on a weekly, bi-weekly, or monthly basis. 

You might see sinking funds referred to as “savings buckets” or other terms. Whatever you call them, they’re compatible with micro-savings apps and other small-dollar savings strategies.

Sinking Fund vs. Other Types of Savings

A sinking fund is a rewarding way to save, but it’s not the only one. How do sinking funds compare against other savings methods? 

Sinking Fund vs. Savings Account

General savings accounts give you a safety net for unforeseen expenses, big purchases, or general budget mishaps. Though they can come in handy when planned expenses arise, they’re not designed to meet specific upcoming expenses. 

A sinking fund sets aside money for a specific goal. 

When you meet your financial goals, you close the account or adjust the goal for that account to plan for a new expense. 

That said, few banks offer products called sinking funds. Most sinking funds are actually traditional savings accounts, money market accounts, and other accounts that pay interest. The difference lies in how you use them.

Sinking Fund vs. Emergency Fund

Emergency funds and sinking funds are very similar, especially when you compare emergency funds to non-target date sinking funds. They’re both used to plan for emergencies. 

In both cases, determining how much money you need to save isn’t an exact science. There’s no perfect way to tell exactly how much an emergency is going to cost you in the future. 

The biggest difference between the two is that emergency funds provide a safety net in the case of any emergency, while sinking funds cover the cost of specific emergencies you expect at some point. For example, you can use a general emergency fund to cover the cost of surprise auto repairs, but if you have a sinking fund dedicated to auto maintenance and repairs, you’d raid it first.

There’s also a big difference in the amount you should save for sinking funds and emergency funds.

  • Emergency Funds. Your emergency fund should be large enough to temporarily replace your income if you lose your job. Experts suggest setting aside three to six months of income, which means your emergency fund will likely need to be larger than any of your individual sinking funds. 
  • Sinking Funds. Sinking funds cover specific emergency expenses. For example, if you need surgery and have a high deductible health plan (HDHP), you may need to come up with a few thousand dollars to get the medical attention you need. In this case, it’s best to set up a sinking fund with a target amount equal to your HDHP deductible. 

Is a Sinking Fund Right for You?

It’s rare to encounter a truly one-size-fits-all financial solution. You’re as unique as your personal finances, and your plan for managing them shouldn’t be the same as your neighbor’s. 

Sinking funds are one exception to this rule. Regardless of where you are in your financial life, there’s a place for sinking funds. 

Even the highest income earners can benefit from saving for large expenses, and turning savings into a regular monthly expense is a positive for everyone. So, no matter where you stand on the income scale, the debt scale, the wealth scale, or any other scale, setting up sinking funds to help you prepare for the future is a good idea. 

How to Create a Sinking Fund

Creating a sinking fund is simple — so simple that there’s no reason to stop at just one. Follow these steps to set up a collection of sinking funds to manage your future expenses. 

Step #1: Make a List of Planned Expenses 

Start by making a list of the expenses you know you’re going to have to pay. As you make your list, consider line items like insurance premiums, holiday spending, annual vacations, and homeowners association fees. Likewise, consider variable expenses like medical expenses and car and home repairs. 

Step #2: Prioritize Your Expenses

Next, prioritize your forward-looking expenses. Take a look at your list and carefully think about what’s most important to you. Put necessities like insurance premiums ahead of wants like an expensive piece of exercise equipment. Give a numeric value to each expense. 

It’s easy to get overwhelmed if you try to tackle too many goals at once. Instead, focus on your three highest-priority goals first. As you meet those goals, you can start working on new ones. 

Step #3: Determine Your Monthly Payments for Each Goal

Next, determine a reasonable amount of money you should save to cover the coming expense. In some cases, such as annual insurance premiums, that determination is easy to make because the insurance company tells you how much you pay each year. In other cases, such as home repairs, you’ll need to research the likely cost and might only be able to come up with an approximate range.

Define a dollar amount for each financial goal. This can be the midpoint of a range if you don’t know the precise cost. 

Divide that dollar amount by the number of months or paychecks you have to save before the expense arises. For example, if you want to go on a $2,500 vacation with your family in a year, you should save about $209 per month, $97 per bi-weekly paycheck, or $49 per weekly paycheck. 

It can be more difficult to decide how much to contribute to sinking funds that don’t have target dates. You never know when these expenses are going to happen, and you want to be prepared. But you don’t want to create financial hardship trying to get there. 

To avoid creating an undue burden for yourself, consider your budget, your income, and your expenses before setting a contribution amount. If money is tight, brainstorm reasonable sacrifices you can make to save money for unplanned expenses. 

If your income is irregular, you’ll also need to consider the regularity of your income, regardless of when you expect the expense to hit. For example, if you own a small business that does abnormally well from September through January, you’ll want to contribute more to your sinking funds during these months and pare back during the slow season. 

Step #4: Open Interest-Bearing Accounts

You can save sinking fund money in a checking account — or put physical cash in envelopes for that matter. But that won’t earn you any money. Open an interest-bearing savings account or money market account for each goal instead. 

When you open the accounts, pay close attention to account minimums, interest rates, and fees. There are plenty of accounts with no fees and no minimums that pay surprisingly high interest rates. These are the types of accounts you want. 

Step #5: Start Saving

Now, start saving your money based on the monthly payments you calculated. Make a point of meeting your contribution goals regularly. If you miss a payment, divide that payment by the number of payments remaining and add it to your contribution amount so you’re prepared when the expenses arise. 

Step #6: Rinse and Repeat

As you meet your highest-priority sinking fund goals, start working toward meeting other goals further down on the priority list. Eventually, all of your sinking funds will be full and you’ll be prepared for just about any expense that arises. 

Sinking Fund FAQs

Sinking funds are one of the best-kept secrets in personal finance, but they’re becoming more and more popular. As they continue to rise in popularity, people are starting to ask questions. These are the most common sinking fund questions and answers. 

How Many Sinking Funds Should I Have?

Some people manage 10 or 12 sinking funds at a time. However, if you start with too many funds, it’s easy to get overwhelmed. Start with your three highest priorities and move down the list as you reach them. 

Where Should I Keep My Sinking Fund?

Some savers keep their sinking funds in envelopes and standard bank accounts. That’s not a good idea. Idle money that’s not earning interest is steadily losing value. 

Instead, keep your sinking funds in a mix of separate savings accounts. Look for high-yield savings accounts and money market accounts that pay the highest interest rates. 

Sinking funds associated with a specific qualifying expense should be held in tax-advantaged accounts. For example, hold your medical expense-related sinking fund in a Health savings account (HSA). 

How Do I Calculate the Amount of My Sinking Fund?

The amount of your sinking fund should be the amount of money you need to cover a planned expense. If the planned expense isn’t a fixed one, do a little research to determine the average cost of the expenses you expect and save toward the high range of the cost. 

Divide the total amount of money you need by the number of months, bi-weekly pay periods, or weekly pay periods you have left before you expect to need the money to determine your monthly contribution. So if you want to save $1,200 for one of your goals in a year, you should save $100 monthly, $46.16 bi-weekly, or $23.08 on a weekly basis. 

Final Word

A sinking fund is a rare financial tool that can improve your financial health regardless of how much money you earn, have, or plan to save. This style of savings normalizes contributions toward your goals, making it more likely you’ll meet them. And you don’t even need a personal finance app to help you.

The key to being successful is giving yourself time to ramp up into the concept. Instead of focusing on everything you want at first, start a few funds for the most important savings goals. When you meet those, move on to lower-priority items.  

Also, where you keep your sinking fund matters. Pay close attention to interest rates, maintenance fees, and minimum balances when you open savings accounts for your funds. To protect and grow your funds, look for high-yield savings accounts with no fees and no minimum balances. 

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