What is a sinking fund, and why do I need one?

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A sinking fund is a way to save money by taking small increments of money at the end of every month and putting them into savings-like funds. The term “sinking” refers to the minimization of long-term debt that may have accumulated. The sinking fund definition can be applied to both personal funds and business bonds.

The purpose of a sinking fund is to compartmentalize your income into several planned categories, which helps you avoid having to dip into your savings account or emergency backup funds.

Why do I need a sinking fund?

Incorporating sinking funds into your financial plans can be useful for several reasons. It allows flexibility when it comes to purchasing higher-priced items and other unexpected expenses without the pain of using your earned savings. 

Sinking funds can also help you organize your finances, help you continue reaching your savings goals and make it easier for you to make purchases that won’t increase your debt. Overall, this strategy will help you develop a growth mindset for your financial plans and help you feel more confident in your decision-making.

Plan and compartmentalize your savings

If you tend to not be organized with your savings, integrating several sinking funds can help keep your finances in order and easy to access. Creating sinking funds with intentional purposes will compartmentalize your income so you have more flexibility in your purchasing.

Spend money without the guilt

Sinking funds have a known purpose, so you can make a larger purchase without feeling the guilt of using money from your savings account. With a sinking fund, you can decide from the start what you want to purchase in that year or time frame with a specific goal in mind.

Prepare for the unknown

There are always expected payments or purchases that you may have not considered when planning your finances. Having a sinking fund for that purpose gives you an extra cushion that is separate from your emergency fund.

Sinking funds are "commonly used to describe money set aside each month for a big, planned expense"

Types of sinking funds

Before pushing money into your designated sinking funds, you first need to decide on which kinds are your priority, depending on your current lifestyle. There are three main categories that types of sinking funds can fall into.

Miscellaneous expenses

These kinds of purchases can vary depending on your current lifestyle and financial situation. Expenses like monthly car or home bills, clothes for an event or even grocery shopping can fall under this category. You can create specific subcategories under these as well, like a car sinking fund or house sinking fund.

Big purchases

This is a fairly vast category of sinking funds that can include many different things, such as a family vacation, a kitchen renovation or even your yearly Christmas gift list. By planning these out, you should be able to have money set aside by the end of the year to easily pay for any large purchases you’ve been planning on.

Unfortunate events

Having a category of funds for unexpected expenses can help you avoid dipping into both your savings, or worse, your emergency funds. If you have an unexpected car issue or broken device, you’ll be able to accumulate funds to make those purchases without feeling the burden of using savings.

How to set up a sinking fund

Setting up a sinking fund can seem intimidating if you’re new to financial planning or this strategy specifically. By following these next steps, you will be able to visualize your financial goals and create an easier transition to a more complex way of saving and spending your income.

1. Decide what types of sinking funds you need

First, you’ll want to decide on your sinking fund categories. If you’re planning a fairly expensive trip at the end of the year, that should be one of your sinking funds. If you have kids that may have unexpected expenses during their school year, you may want to create a sinking fund for that purpose. 

You can keep the list short to avoid being overloaded with too many pockets of savings. We advise you to write out your sinking funds under the categories listed above to help give you a bigger picture of your financial plans.

2. Choose how you will be storing your sinking funds

When thinking about where you want to store your sinking funds, you need to be smart and think about how you handle your money. If you’re disciplined with your savings, you can create a separate savings account at your bank just for your sinking funds. 

If you want to avoid creating new savings accounts for your sinking funds, try taking out cash every month and put it into physical cash envelopes. This way you can visually see how much money you’re putting into each of your sinking funds and keep it organized.

3. Solidify how much you want to save

It’s important to decide on your savings end goal for each of your sinking funds. Remember to understand how much net income you will be receiving monthly before deciding your sinking fund goals. 

You will then want to decide on the number of months you want to save money. This can be up to 12 months or longer—it solely depends on your current income and funding goals. Finally, you’ll need to evenly split up the total amount of money for your goal throughout the timeline by month. 

Example monthly sinking fund budget

How much should I contribute?

This all depends on the types of sinking funds you decided on and your monthly income. If you have larger categories like an expensive vacation or house renovation, you may want to increase the amount in those versus sinking funds that will not need as much. When deciding on your goals for your sinking funds, think about the logistics of how much you can attribute to the funds without feeling overwhelmed at the end of every month.

Sinking funds vs. savings accounts vs. emergency funds

While savings accounts and sinking funds seem similar, they are handled a bit differently, and each has specific purposes. A savings account is different from a sinking fund because it is simply one large general pot of savings. 

This money can be used similarly to how a sinking fund is used, but it is much easier to split your savings into specific categories. The true purpose of a savings account is to reach your financial goals over the long term, while your sinking funds are designated for more short-term uses. 

An emergency fund is vastly different from both sinking funds and a savings account. An emergency fund should be the very last thing touched if an emergency expense arises. A sinking fund has a known purpose with a specific amount set aside for it, while an emergency fund’s purpose may be incredibly unexpected. 

A sinking fund allows you to make larger purchases throughout the year while you keep growing your personal savings account and keep your emergency funds untouched.

Does this affect my credit score?

By creating intentional sinking funds, you allow for extra financial padding. Compartmentalizing your expenses and purchases will help you avoid swiping your credit card and racking up unnecessary debt. By not having as much debt, you won’t have to worry as much about negatively impacting your credit score. 

If you implement this financial strategy correctly, you won’t see a direct impact on your credit because you’ll avoid increasing your credit balance. If you want to learn more about how to improve your credit score, there are financial podcasts you can listen to that will help educate you more. 

Incorporating the strategy of sinking funds into your financial plan will help you maintain good credit health. The most important thing as a financial planner is to educate yourself in understanding how good credit can help you in the long run. If you still find yourself increasing your credit balance, we recommend that you regularly check your credit score and see what you can do to improve your credit.

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