It's challenging to cover a significant expense in a short duration. Some people go into debt over it. A well-established sinking fund helps shield life's unexpected events, protects your financial goals, and promotes better budgeting.
What Is a Sinking Fund?
A sinking fund is a cash reserve in your account that holds calculated funds for future expenses. There is usually a stand-alone account for each sinking fund category. This account is separate from your regular checking, savings, and emergency fund.
Your strategy should be to set aside a portion of your monthly income to let the sinking fund grow. The sinking fund you create can either be a set target amount for planned expenses or a general saving account for future expenses that are unplanned but necessary.
Sinking Fund Vs. Emergency Fund
A sinking fund might sound like an emergency fund, but it is not. They have two separate structures. An emergency fund is a general fund, whereas a sinking fund is specific to the expense category.
The emergency fund is your last resort; therefore, you do not dig into it until you run out of all your resources. It covers emergency expenses you've never anticipated, like losing an income source and needing to survive for months without a job.
Sinking fund expenses are predetermined or anticipated, i.e., saving for a vacation, house down payment, car down payment, or home repairs. Sinking funds provide a cushion to an emergency fund.
What Is the Purpose of a Sinking Fund?
The purpose of a sinking fund is to have enough liquid cash savings to cover anticipated expenses. A sinking fund supports costs related to life events and assets.
Below are some reasons you need to set up a sinking fund.
Cover Planned Expenses
The planned expense could be something as small as a gift purchase or Christmas costs or as big as a family vacation and furniture purchase. Without sinking funds, these expenses will come out of your checking account. However, using one account to pay for all costs is never wise.
A sinking fund established for each planned expense helps streamline the budget. Knowing where the money comes from when you need it provides financial security and peace of mind. A sinking fund holds cash through monthly or biweekly savings to prepare for a future planned expense.
Cover Unplanned But Anticipated Expenses
Medical bills, home, auto repair, and maintenance are some anticipated but unplanned expenses. While you can't determine an exact budget for these things, planning for them is necessary.
A sinking fund set up for unplanned but anticipated expenses helps prevent them from being an emergency. Unexpected expenses have a sneaky way of eating away at our savings. A sinking fund helps offset budget deficits.
Protect Emergency Fund
We set up emergency funds hoping we never have to use them. A rainy day fund takes care of life's unexpected events. You'd never expect to lose your job, yet, it is not uncommon. The COVID-19 pandemic forced 114 million people to lose their jobs over 2020.
A well-planned sinking fund helps protect life's volatile circumstances. It prevents them from becoming a financial crisis. You can set up a sinking fund for items that can catastrophically impact your budget and start building cash reserves. The sinking fund will be ready to cover your expenses when needed.
Promote a Good Budgeting Habit
Setting up a sinking fund is a sound financial decision. It is a way of forward-thinking about financial responsibilities. By having a sinking fund in place, you're saving up money for the items you (may) need in the future. This is good budget building through sinking funds.
You'll set up sinking funds by transferring some of your earnings. You contribute to these funds every month and let them grow.
According to the Bank rate's July 2021 Emergency Saving Survey, 51 percent of Americans don't have three months' expenses saved in their emergency fund. Their last resort to cover the cost is to go into debt; it's no wonder that national debt has surpassed $30 trillion.
A well-established sinking fund covers life's unanticipated circumstances. You are not required to come up with a considerable amount of money in a short time. It protects you from going into debt.
Sinking Fund Categories
You can establish a sinking fund for every event or expense. Therefore, it is always best to categorize them by combining small funds into one expense category. Sinking fund categories help organize savings and promote responsible spending when needed.
Below are some sinking fund categories.
A medical fund is necessary to cover health, dental and vision costs. Health Savings Account (HSA) and Flexible Spending Account (FSA) can act as your medical fund. The contributions and deductions are both tax-free. If you're eligible for an HSA plan, you can also help grow money through investments.
Americans, on average, spend $397 each year on car maintenance and repairs. While it does not sound like a lot of money, a car replacement may be necessary.
Owning a car is essential for most Americans who can't afford to lose the freedom a car provides. It's prudent to build a fund that takes care of this essential item. A car care sinking fund can cover regular maintenance, repair, or a down payment on a vehicle.
A car care sinking fund is a must if you can't afford to go a day without a car.
Homeownership has always been the American dream. A home is a shelter for your family, and you can't let another day go by without keeping your dream protected. A sinking fund for a house can put money toward purchasing a home. It can be a down payment, closing cost, or anything associated with the purchase. A home fund can save money for future repair and maintenance if you're already a homeowner.
There are many advantages to owning a house, but it's not cheap. The cost of ownership can weigh you down if you can't afford to take care of the expenses. For example, a regularly financed home sinking fund can take the stress away should any major appliance break down.
The average cost of having a baby ranges from $13,00 to $23,000. According to the Consumer Expenditure Survey in 2015, families spend an average $233,610 raising kids from birth through age 17. It would be unwise not to set up a fund to take off most, if not all, of the expenses associated with raising a child.
Baby funds may include getting ready for pregnancies, baby deliveries, and buying baby supplies and children's college funds. You should explore the kid's college fund 529 plan, which has a tax benefit for education. Your HSA or FSA can cover health-related expenses. For everything else, you should establish a separate fund.
The other miscellaneous fund can be for a vacation, holiday gifts, birthday parties, travel, or a wedding. You can set up a separate sinking fund for anything that you believe is substantial and necessary. Some of these funds may be combined or be stand-alone if it is a considerable expense.
How to Set up a Sinking Fund?
Now you've realized a sinking fund is necessary, you need to set it up separately from your checking account. Follow the three steps below to build your sinking fund.
1: Determine How Much You Need And When You Need It
The first step of setting up a sinking fund is determining how much to put into it. It is the forecasted amount you may need. You don't need an exact amount, but a ballpark number should be a good starting point. Use an average in cases where it is impossible to determine a precise number.
Time is another crucial factor to consider when setting up a sinking fund. Planned events like a vacation or celebrations have exact dates for when we will need them. Anticipated events like auto and home repairs are not easy to predict based on their life cycle yet it is possible to expect them.
2: Determine Where to Store Funds
It matters where you park your sinking funds. These funds must be quickly and easily available when you need them. At the same time, you don't want to pay any fees for their maintenance.
Internet banks are the perfect place for maintaining a sinking fund. Most, if not all, internet banks have no minimum balance requirement and no monthly fees. Internet banks offer higher-yielding savings and money market accounts with higher interest rates than regular brick-and-mortar banks.
You can open as many accounts as you want. Choose any internet bank that is Federal Deposit Insurance Corp (FDIC) insured to build your sinking funds.
3: Determine How to Save Money
Determining how to save money for sinking funds depends on the fund type, income level, and how you generate income. The best method to build a sinking fund is through the automatically scheduled transfer of your income. It could be biweekly or monthly. An automatic transfer ensures commitment toward saving.
A sinking fund grows over time. The best way to build one is by saving every month.
The Bottom Line
Sinking funds set you up for financial protection. It's your responsibility to cover these events, and the only way to safeguard your finances is through a properly established sinking fund.
A sinking fund can help you in many ways, from minimizing your financial risk to supporting your financial planning. It takes only a few minutes to set up and automate, so you don't have to think about it anymore. I encourage all to get started with a sinking fund.
This post originally appeared on Savoteur.
Prakash Kolli is the founder of the Dividend Power. He is a self-taught investor and blogger on dividend growth stocks and financial independence. Some of his writings can be found on Seeking Alpha, InvestorPlace, Business Insider, Nasdaq, TalkMarkets, ValueWalk, The Money Show, Forbes, Yahoo Finance, and leading financial blogs. He also works as a part-time freelance equity analyst with a leading newsletter on dividend stocks. He was recently in the top 1.0% and 100 (81 out of over 9,459) of financial bloggers as tracked by TipRanks (an independent analyst tracking site) for his articles on Seeking Alpha.