You’re no doubt aware of what an emergency fund is. You may not be as aware of what a sinking fund is. A sinking fund is just as important as an emergency fund in a lot of ways, and it has a similar purpose within your personal finances.
What Is a Sinking Fund?
Much like an emergency fund, a sinking fund offers protection against future costs/expenses. The critical difference between the two is that the emergency fund is used to cover unexpected expenses like your car breaking down or your hot water system exploding. A sinking fund is designed for expenses that you anticipate.
What Is A Sinking Fund Used For?
At this point you’ve probably already developed a budget and are wondering, aren’t anticipated expenses in my budget? Some are, but what about one-off costs? Christmas presents and birthday presents are some of the most common uses of a sinking fund. They’re regular expenses that are difficult to place in your budget as they only come around once per year. A sinking fund allows you to put small amounts of money away over the year to avoid trying to find the money at the last second.
Sinking funds can be used for more than birthday and Christmas presents. If you’re anticipating that you may need to buy a new computer or car because your current one is starting to look or sound a little worse for wear. A sinking fund is a perfect place to start saving. You could even use a sinking fund to save for a vacation.
How Much Should Be in My Sinking Fund?
Sinking funds will differ in size for everybody. As with an emergency fund, the more you put in, the less you have for investing. For this reason, you should determine what one-off expenses you are anticipating for the year. Everything from birthdays to Easter and maybe a family holiday. Determine roughly what all of this will cost and then start saving the appropriate amount weekly, fortnightly or monthly.
As with an emergency fund, everybody’s sinking fund will be a different size. It really comes down to what you’re comfortable with. As similar is that the size of an expense may not be fully known even if it is anticipated. You can’t predict to the exact dollar what a holiday will cost nor many other expenses. For this reason, a sinking fund is as much art as it is science.
To determine how much, you should be allocating to your sinking fund:
- Determine your anticipated costs for the year
- Calculate when you when need the money for each
- Divide the amount that you need by the number of paydays before that date
- Create an account to send this money to
- Set and forget with automatic payments every payday
Where Do I Put My Sinking Fund?
Expenses that you will be paying with your sinking fund are in the short-term future. Therefore it is not a wise move to invest them in anything overly volatile or illiquid asset. Needless to say, your sinking fund will not be invested in the stock market. You will need this money soon, and you can’t afford for it to fall 20-30%. So where should you keep your sinking fund? Somewhere the value won’t change much and somewhere you can withdraw it from at any time. For these reasons, most people will maintain their sinking fund within a savings account. To make things as simple as possible, it’s best to put this money in a separate account to your everyday money and also to your emergency account. If you need to create a new account with your existing bank or even a new one, be sure that the account has no fees associated with it.
When Should I Start Building a Sinking Fund?
The single most important thing in your financial life is ensuring you stay out of debt. If you own money on a credit card or loan, that is always your first priority. Whether you choose the avalanche or snowball method to pay it off doesn’t matter as much as actually paying it off. Once your debt-free your next goal should be to create a level of safety against unexpected expenses in the form of an emergency fund. Then, when you’re starting to feel comfortable with your finances, it’s an excellent time to create a sinking fund. Then you’re ready to begin investing.