Sinking funds and emergency funds are two ways to save money to cover big expenses. Both prevent the need to dip into a long-term savings account or retirement account or take out a loan to pay bills, but they have distinct uses and maintenance requirements. Understanding the differences between them can help you avoid taking a major hit to your finances and keep you on track toward your financial goals.
Basics of Emergency Funds
As the name suggests, this is a pool of money that you can draw from to cover unexpected lapses in income or bills, such as a job loss, surprise medical expenses, or emergency home or car repairs, without having to dip into your savings or borrow money. The size of the fund depends on your income and expenses, but it's prudent to maintain three to six months of take-home pay. However, some experts recommend keeping as much as eight months of pay, which is prudent if you are single or the sole earner in your household.
You put that money in a separate account from your day-to-day checking account and only draw from it when an emergency strikes. Most importantly, whenever you tap the fund, replace the funds you used so that you always have money for future expenses.
An easy way to start an emergency fund is to divert 2% of every paycheck you receive to the emergency savings account. Then, increase your savings rate by another 1% to 2% every six months to a year until you have the optimal reserves in the account.
Sinking Fund Fundamentals
You set up a sinking fund to save up money to cover an upcoming expense. You may do this to purchase a new car, go on vacation, or repair your roof; whatever the expense, a sinking fund is generally used to cover a planned expense whereas an emergency fund exists to cover unplanned expenses. A Health Savings Account is a good example of a sinking fund.
Setting aside money in advance for upcoming expenses prevents the need to tap your long-term savings or rack up credit card debt. You can open a single account to hold your entire sinking fund. But since you may have multiple upcoming expenses, it's a good idea to set up multiple accounts—one for each category of expenses or even one for each individual expense. For example, you can establish one account as your new roof fund and another as your new car fund.
As with your emergency fund, you can allocate a small percentage of every paycheck to your sinking fund to grow it on autopilot. Or, wait until the end of the month and manually transfer a large chunk of money from your day-to-day account into the designated account. You can either split that amount equally among all your sinking fund accounts or allocate a higher portion for larger expenses or categories of expenses.
Unlike with an emergency fund, the amount you need in each sinking fund account depends on the estimated cost of the expense. Once you have saved that amount, you can safely spend it for the specified expense, and there's no need to replenish it.
In general, having a sinking fund prevents the need to dip into your emergency fund. But there may be times when a planned expense, like a roof repair, becomes an unplanned expense, such as a leaky roof that requires immediate replacement. If you don't have enough in your sinking fund to cover the expense, you may need to tap your emergency fund to cover the difference.
Best Accounts for an Emergency vs. Sinking Fund
Whether you're setting up a sinking or emergency fund, it's imperative that you use a low-risk, FDIC-insured account to preserve your money until you need it; it's inappropriate to invest these funds in the stock market because you stand to lose any money you contribute. With an interest-bearing account, the fund will grow little by little over time.
You want your emergency fund to be easily and immediately accessible so that you can take out money when needed, making an online savings account, money market account, or no-fee interest checking account good options.
You still need liquidity with a sinking fund, albeit less so, since you'll use the fund for an expense in the short or long term as opposed to right away. You can rely on the same accounts as you would for an emergency fund, but also consider certificates of deposit (CDs), which are like savings accounts but come with higher, fixed interest rates and usually impose penalties if you withdraw funds before the CD's maturity date.
Spending Categories in a Sinking Fund
Unlike emergency funds, which you can budget for in terms of a certain number of months of expenses, sinking funds require you to identify what, specifically, you're saving for so that you can estimate how much you need for the expense and then save until you meet that goal. There are three categories of expenses to include in a sinking fund:
- Recurring expenses: These are large expenses you pay for on a regular basis, such as quarterly estimated taxes or annual property taxes or life insurance premiums.
- One-time purchases: These might include a new computer or phone, a car, or even a down-payment on a house.
- Events: This category includes vacations or planned gifts for weddings or graduations.
Creating a Saving Schedule
Once you determine the categories for your sinking fund, regularly contribute enough to the account or accounts to cover that category or the specific expenses within it by the time the bill or event arises.
For example, if you choose to establish one account for event-related expenses and have $1,200 in expenses planned for the year, save $100 every month to meet your goal. If you prefer separate accounts for each expense, and pay roughly $5,000 in property taxes every year, divide that amount by 12 to determine how much to contribute to the property tax account each month ($417).
Use a sheet of paper or budgeting software to keep track of the different accounts you use for your sinking fund and how much money you have set aside for the different categories or expenses inside each.
The Bottom Line
Both emergency funds and sinking funds make your budgeting process easier and give you more freedom to do the things you want with your money. With few exceptions, emergency funds are used for unplanned expenses such as car repairs while sinking funds are used for planned expenses like vacations.
The longer you budget, the more you will recognize expenses for which you should have a sinking fund. For example, if you wear glasses, you might want to save up for them every year. Similarly, you replace the tires on your car every other year or so; the first time, you might not have planned for it, but now, you might see that you need to set aside money to cover the expense. For these and other large expenses, a sinking fund can keep you from scrambling to find the money to pay them.
Eventually, you will be able to budget so well that you will only need to use your emergency fund when you lose a job or experience a catastrophe; otherwise, you can use sinking funds to cover the purchases.