Get our FREE Guide: 21 Days to a Better Financial Life!
Have you ever heard of a budgeting tool called a sinking fund? If you haven’t, today, I am going to share with you everything you need to know about sinking funds and why they are a total game-changer for your finances. I’ll cover what a sinking fund is, why you need one is, how they work, and much more!
What Is a Sinking Fund?
Let’s start with the basics: what is a sinking fund?
A sinking fund is a relatively simple concept. All it means is that you allocate money regularly towards future planned spending. When that planned spending occurs, you will have already set aside the necessary funds to cover the expense.
Is that it? Really? Yes, that’s it!
But while it’s a straightforward concept, it has the potential to have significant effects on your financial situation.
Why Do I Need a Sinking Fund?
The reason why you NEED a sinking fund is that it will allow you to take a proactive approach to spending money rather than a reactive approach. For example, let’s say you pay your insurance bill every six months. Do you usually plan every month for that bill, or do you forget about it until the bill shows up?
If you’re anything like I used to be, chances are you would forget about it until you got the bill.
The problem with this approach is that when you don’t plan your spending, you’ll get hit with lumpy expenses, many of which have the potential to derail your financial habits and cause financial panic.
To give an example from my own life, I carry a credit card with a $450 annual fee. While this is substantial, this card typically pays for itself many times over.
Before I used sinking funds, I would often be surprised by this annual fee. As an example, it would be the 20th of the month, and I’d think my credit card balance was looking pretty good for the month. And then all of a sudden, WHAM, a $450 charge hit my card. Then, suddenly, instead of feeling good about my spending for the month, I’d worry about how I was going to come up with an extra $450 to pay my bill.
This is why you need a sinking fund. The purpose of a sinking fund is to allow you to plan to spend, so you’re never surprised when you get a bill.
How Do Sinking Funds Work?
The way that sinking funds work is quite simple. The sinking fund formula is as follows:
(Total Expected Spending) / Time Horizon = Required Savings per Month
Sinking Fund Example
For example, let’s say you have an insurance bill that comes once per year, and it costs $1,000. So, if you have 12 months to prepare for that bill, you’ll take $1,000 divided by 12 months, which equals $83.33. That means if you set aside $83.33 every single month, by the time your insurance bill comes, you’ll already have all the money to pay the bill!
This spending is no longer surprising, and it can no longer derail your budget!
Uses of Sinking Funds
Above, I have outlined two examples of sinking funds, one for a credit card annual fee and one for an insurance bill. But there are so many more great uses for sinking funds!
Planning expenses like insurance is one use of sinking funds, but you can also use sinking funds to plan for big purchases.
Say you want to take a vacation with your family and it’s going to cost $3,000. You’d like to take this vacation six months from now. So, use a sinking fund to set aside $500 per month, and by the time you take the vacation, you’ll already have the money to pay for it!
Expecting the Unexpected
Another use of sinking funds is to help cover unpredictable expenses. For example, you may not know when your car is going to need maintenance, but you know it’s going to need maintenance eventually.
So, in this case, you can set aside money every month to cover future spending. While you may not know when this spending will happen, or even exactly how much it will cost, you will have allocated money in your budget to cover this expense.
If you set aside $100/month, and suddenly six months from now, your car needs new brakes, which cost $600, it’s no big deal. You already have the money saved!
Lose the Guilt
Finally, sinking funds can help make spending guilt-free. Have you ever bought something and then immediately felt buyer’s remorse because you know you shouldn’t have spent the money?
If you use a sinking fund, instead, you are making a conscious choice about allocating your spending in a way that is consistent with your priorities.
Let’s say, for example, you want to buy a new phone, and it will cost $800. If you plan to make this purchase in 12 months, you’ll want to set aside $66.67/month. When you do end up spending that money, you won’t feel guilty. You’ll feel good about it! You’ll already have the money, and you will have made a conscious choice to spend on your financial priority!
Why Can’t I Just Use a Savings Account Instead of a Sinking Fund?
The “secret sauce” to sinking funds is allocating funds to specific purposes.
Some people ask why they can’t just use a savings account for expenses like this. There are a couple of reasons I strongly advise against doing so.
- Savings accounts are for saving; sinking funds are for spending
- Savings accounts are one mixed pot of money; it’s not easy to allocate to specific purposes
First, it is okay to have a bank account for your sinking funds (i.e., the money you intend to spend). However, I suggest you keep these funds separate from your general savings so that the two are not commingled.
Second, if you have multiple sinking funds, it can be tough to keep track of which money is allocated to each purpose if lumped together into one account. One solution is to have a bank account for each specific sinking fund. However, this gets very messy and difficult to track.
There is, however, a better way. I will share my favorite way to track sinking funds in just a minute!
Sinking Fund vs. Emergency Fund
Many people also ask how a sinking fund is different from an emergency fund. The critical difference is that sinking funds are for spending that you expect, versus emergency funds are for unexpected emergencies.
As an example, maintenance for your car or house is not an emergency. You know cars require maintenance, so it should never come as a surprise.
By setting money aside each month in a sinking fund, you’ll be able to cover this spending when it happens.
Emergency funds, on the other hand, are for expenses you couldn’t reasonably anticipate. As an example, you probably can’t anticipate losing your job or ending up with a substantial medical bill. These are true emergencies, and times you should use an emergency fund.
What Sinking Funds Should I Have?
Now that we’ve covered what a sinking fund is and how it can help you take a more proactive approach to your finances, let’s cover some common sinking fund categories:
- Insurance (you can often get a discount if you pay annually)
- Home Maintenance
- Car Maintenance
- Car Registration
- Annual Subscriptions (annual credit card fees, Amazon Prime, etc.)
- New Car (because your current one will eventually require replacement)
- Holiday Spending (check out some ideas on how to implement sinking funds for holiday spending)
- Charitable Giving (i.e., if you donate a couple of times per year)
Everyone is going to have different sinking funds because no two people have identical spending patterns. However, the above are some common sinking funds to consider.
However, with so many sinking funds, you may be wondering where you should keep your sinking funds, so they’re easy to track!
Where Should I Keep My Sinking Funds?
As I explained above, one option is to have a separate bank account for each sinking fund, but if you have ten sinking funds, this isn’t very easy to track.
Another option is to use one bank account and track the allocation of money in that account for different purposes using some sort of spreadsheet. While this can work, frankly, this, too, is a complicated solution.
So, what do I do if the above solutions don’t work well? I use my budget to track my sinking funds. I have one bank account with money allocated to specific purposes using my budget.
Building Sinking Funds into Your Budget
There are a couple of unique budgeting solutions that allow you to plan your spending proactively. Two of the most popular solutions are You Need a Budget (YNAB) and EveryDollar. Both of these budgeting solutions allow you to create sinking funds to plan future spending.
YNAB is the solution that I use, and I think it is the best budgeting software on the planet. Leveraging sinking funds in YNAB has removed the “surprise factor” from my spending and drastically lowered my financial stress.
The above screenshot shows many of my sinking funds in YNAB. As you can see, I have quite a few planned future expenses, so I need a way to track them efficiently. Some expenses are small, like $119/year for Amazon Prime, while others are substantial, like my property taxes.
The far left-hand numerical column shows how much I’ve budget this month towards the sinking fund. The middle column shows my spending activity this month. As you can see, for example, I had to pay my $450 annual credit card fee this month. And the third column indicates how much I have available in each of these sinking funds.
As you can see, I don’t need a separate bank account for each sinking fund because I use YNAB to allocate money to categories. Regardless of my bank account balance, I know how much I have set aside for each sinking fund. Every dollar has a defined purpose.
Creating sinking funds in YNAB drove perhaps the single most significant improvement I have experienced in my financial life. I am a big believer that they can help you take a more proactive approach to spending as well. Check out this FREE trial of YNAB to give it a shot for yourself.
What is A Sinking Fund: A Summary
I hope you now have a clear understanding of what is a sinking fund and how it can help you better plan your spending.
Sinking funds help you create a more proactive approach to spending, reducing stress, and the “surprise factor” of recurring bills or unplanned spending like vehicle maintenance.
There are lots of uses for sinking funds, and I hope you’ve identified some opportunities where they can help you in your financial life.
So, get started and start creating your sinking funds today! And if you’ve enjoyed this post, please be sure to share it on Pinterest!