What Is the Difference Between a Sinking Fund and an Emergency Fund?
Sinking funds and emergency fund are two different ways that you can save money to cover big expenses. Some expenses you know are coming, but you are not exactly sure when you will need the money. For example, you know you need to replace the brakes on your car, but you are not sure when you will need the money. You can use a sinking fund to cover that expense by setting aside money each month to cover it. Emergency funds are designed to cover unexpected expenses or losing your job. As you become better at budgeting, you will use more sinking funds to cover your bigger expenses.
Each person should have an emergency fund of about one month's expense to cover unexpected bills while they are getting out of debt. After that, they should work on building up a year's worth of expenses to cover times when you lose a job or you are unable to work. If you are single or a one income household, it is essential to have at least a year's worth of expenses saved up. This will give you the time you need to find a job without getting truly desperate.
When you set up a sinking fund, you are basically saving up money to cover an upcoming expense. You may do this to purchase a new car, go on vacation, replace your furnace, or repair your roof, while an emergency fund is in place to cover the unexpected expenses that can happen. This could be an unexpected car repair, an unexpected medical bill, or an emergency flight home to your parents. Sinking funds may cover unexpected bills that are likely to happen, for example, you know that you will need to fix your car at some point, but you are not sure when.
A sinking fund allows you to put the money aside ahead of time so that you do not have to access your emergency fund. A Health Savings Account is a good example of a sinking fund.
What Accounts Should I Have for My Sinking Funds?
You can set the funds up so that they exist in the same savings account, but it is a good idea to keep the amounts separate. You can do this on a sheet of notebook paper or in your budgeting software. This allows you to see how much you have set aside for each category, but it also keeps the money separate from your checking account and your daily transactions. You want your emergency fund to be easily accessible so that you can get the money quickly if needed, Some of the expenses can be planned for, so an online savings account that allows you to earn a higher interest rate may be a good option.
Are There Categories That Need a Sinking Fund?
The longer you budget, the more you will see items that you should have a sinking fund for. For example, if you wear glasses, you buy them every year so you should plan to save up for them every year. Similarly, you replace your tires on your car every other year or so, and the first time you may not have planned for it, but now you can see that you need to set aside money to cover the expenses. If you drive an older car, it is a good idea to go ahead and set aside money to cover the cost of future repairs on the care.
Eventually, you will be able to budget so well that you will only need to use your emergency fund if you have lost your job or have a major catastrophe, otherwise you will use sinking funds to cover the purchases. Here are additional reasons you may want to set up sinking funds.
- Insurance payments,
- Expected medical expenses
- Home remodeling
- New car fund
How Do I Know How Much to Save for Each Category?
Similar to choosing the right account for an emergency fund, you need to choose the correct account for your sinking fund. You want the money to be easily accessible and safe. This means that you do not want to invest the money in your sinking funds in the stock market or something similar. It also means that you need to carefully consider all of your account options. A money market or CDs will allow you to earn more interest on your sinking funds while still making the money easy to access.
If you have a large expense, like annual insurance premiums or taxes, set up a sinking fund for it. This can keep you from scrambling to find the money to pay it each month. It will make your budgeting process easier and give you more freedom to do the things you want to with your money. As you keep budgeting, you will begin to find the big expenses that you may not have thought about. After about two years, you should be able to identify most reasons that you need a sinking fund and begin to establish enough that the expenses should not throw off your budget.
Managing your money will become much easier.