What Is a Sinking Fund?

What is the purpose of a sinking fund?

When it comes to sinking funds, there are no strict rules you have to follow. The key to a successful sinking fund is to personalize it to your financial needs. Unlike a general savings account, the purpose of a sinking fund is to put aside money for a specific purchase with a target amount, funding schedule, and goal date. With this intentional type of saving, you can build up the money you need for specific large purchases and gain confidence when you achieve your targets. 

To keep them separate from your general savings, sinking funds are often represented as designated line items on a balance sheet, which helps you stay on track with each of your goals. The sinking fund strategy is typically best for short- and medium-term goals, rather than long-term savings goals that might be better suited for investmentment accounts instead of saving accounts. 

Examples of sinking funds

Sinking funds can be used for a variety of larger purchases you need to fund, which could be necessary living expenses or things you desire. Here are some common examples:

Sinking funds vs. emergency funds

If you already have an emergency fund, you might wonder why you’d need a sinking fund as well, or how the two differentiate. While sinking funds are typically smaller, with a set target amount and timeline, emergency funds are usually larger and aim to cover several months’ worth of living expenses. 

Sinking funds are intended for specific savings goals with a set target amount and timeline; the idea is to use them for specific goals and not spend the money on unrelated expenses. Emergency funds, on the other hand, act as a safety net for unanticipated financial emergencies like job loss or medical expenses, providing you with a financial cushion during difficult times. You can set up sinking funds for unpredictable expenses that you anticipate happening in the future, such as car repairs or medical needs, in order to reserve your emergency fund for things you have no way of foreseeing. Having both types of funds can help you tackle different financial situations.

Advantages of a sinking fund

Sinking funds can offer several benefits when it comes to managing your money. Here are some of the benefits of maintaining a sinking fund:

• Avoid going into debt for big purchases: Saving ahead for larger purchases and expenses like a vacation or a new car can help prevent you from incurring debt and racking up interest charges on the money you borrow. 
• Protect your emergency fund: When you have a sinking fund dedicated to specific goals, you’re less likely to tap into your emergency fund for those purchases, ensuring it remains available for true emergencies you can’t anticipate.
• Earn interest on your savings: Depending on the type of savings account you use to store your sinking fund, you can earn interest on your money, helping you reach your goals faster.
• Stay motivated to save: Having a clear goal and timeline can keep you motivated to stick to your saving habits, reducing the temptation for impulse spending.
• Reach your goals: With this type of savings strategy, you’re more likely to achieve your financial goals and enjoy the satisfaction of spending the money you’ve saved up.

How to set up a sinking fund in six steps

Creating a sinking fund is straightforward, but it requires planning and dedication if you want to be successful. Here are six steps to help you set up and start building your sinking fund.

1. Determine your savings goals

How much money you should keep in a sinking fund depends on your goals, income, and expenses. Start by identifying what you want to save for and how much you’ll need. Think about any upcoming expenses such as bills, gifts, travel, or debt repayment. You might have regular bills or purchases occurring with different frequencies and at different times throughout the year. Write down each specific goal and prioritize what’s most important for you.

2. Choose a target date

Establish a date by which you need the money for your savings goal. This date can be fixed or flexible, depending on the nature of your goal. For instance, if you’re putting aside money for a wedding, you’ll likely have a date set for your nuptials. If you’re saving for an unpredictable but likely expense like orthodontics, you might have a more flexible timeline, so you can choose a date by which you’d like to have the money available. 

3. Create a funding schedule

Your funding schedule will likely depend on two factors: when you’ll need each goal’s full amount and how much of your paycheck you can afford to put away. First, determine the amount you want to save for each goal. If you know exactly what it will cost, set a specific savings target. If the amount varies, estimate how much to save based on previous expenses and the average cost of what you’re saving for. Next, decide how frequently you’ll contribute to your sinking fund and calculate your contribution amount accordingly. Many people put money into their sinking funds every month so they’re building up their savings slowly but surely over time.

4. Incorporate savings into your budget

Review your budget and make sure your savings plan aligns with your income and expenses. Now that you’ve set saving goals, you might need to make some adjustments to your budget. If you don’t have enough in your budget to fund your goals, consider finding ways to trim your expenses or ways to add new income through a side hustle. If possible, you could also move your sinking fund’s target date or consider less expensive options. 

5. Decide where to store your savings

Before you start setting money aside, you may want to separate contributions to your sinking fund from your regular checking account. Here are a few possible account options:

• Savings account: Open a savings account specifically for your sinking fund. While not all savings accounts earn interest, keeping your sinking fund separate from your checking account can help you avoid accidentally spending what you’ve saved. Be aware that some accounts may have a minimum deposit requirement or require you to maintain a minimum balance.
• High-yield savings account: If you’re looking to maximize the growth of your sinking fund, consider a high-yield savings account. These accounts typically offer higher interest rates to help grow your savings, but they may have higher minimum deposit requirements and additional rules you’ll need to follow in order to earn the highest interest rate.
• Money market account: Money market accounts can often provide higher interest rates compared to regular savings accounts and offer check-writing capabilities. However, they may have higher minimum deposit requirements and certain restrictions compared to traditional savings accounts.
• Certificate of deposit (CD): CDs offer a fixed interest rate that’s often higher than other savings vehicles in return for keeping your money in the account for a set amount of time. If you know your target date and already have some funds to put into your sinking fund, a CD may help you take advantage of a higher interest rate. 

By selecting a separate account for your sinking fund, you can protect your savings from accidental overspending and potentially earn interest, helping your money grow over time.

6. Start saving

Once you’ve set up the account of your choosing and your sinking fund is incorporated into your budget, it’s time to start making regular deposits on the schedule that works for you. The more automatic you can make the deposits, the better. Setting up automatic transfers from your paycheck or checking account can help you stay consistent with your contributions and avoid the temptation to spend money that you intend to save. Don’t forget to track your progress and celebrate your milestones when you achieve your goals. 

How to manage multiple sinking funds

Having more than one savings goal doesn’t mean you need multiple savings accounts. With a spreadsheet or budgeting app, you can store all of your sinking funds within a single savings account and track your contributions separately. Many online banking tools and budgeting apps offer tools to make this process easy.

Alternatively, you can open individual savings accounts for each sinking fund, but keep in mind that this approach may become complicated to maintain with multiple goals and shorter timeframes. You might want to choose this strategy if you only have a couple of longer-term savings goals.

Reach your goals with sinking funds 

Sinking funds can help you tackle your savings goals with clarity, purpose, and a higher chance of success. Building healthy savings takes time, so remember to stay committed, make adjustments when needed, and take time to appreciate your progress as you make your way toward your goals. 

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