Have you ever heard the term sinking fund? A sinking fund is a sum of money that you set aside (usually by saving a bit each month) that's completely separate from your savings account or your emergency fund.
A sinking fund can be used to pay for home repairs, save for a new car, pay for your vacation, or cover large medical bills.
By setting the money aside before you use it, you will avoid using your emergency fund unnecessarily. Plus, you give yourself more negotiating power when it is time to purchase. Some businesses also use the term sinking funds for planned expenses.
When it comes to personal finances, a sinking fund is a great financial safety net. It keeps you out of debt, on budget, and on track for your financial goals.
When Should I Use Sinking Funds?
There are a number of different reasons and ways to use your sinking funds. If you have a planned expense, (such as a vacation), or an annual expense, (like preschool tuition), you can set up a sinking fund for it.
Things like your vacation, home remodeling, and taxes could all have sinking funds. Even if you do not know the exact cost, it's still a good idea to set up a sinking fund for a major expense. That way, at least part of the expense is covered. For example, you can set up a sinking fund to cover medical expenses.
When you set up your sinking funds, you will need to decide on how much to allocate for the fund. Then divide that amount by the number of months you have until you make the purchase or you expect the expense. Finally, you add these amounts to your budget, to be sure you have enough money to cover all your monthly expenses, plus your sinking fund.
If your sinking fund is for something like a car repair or medical expenses, you may have to determine how much you would like to have in the fund without knowing the actual cost. You can set aside the money until you reach that amount. Once you use the money in the fund, you can then replenish as needed
Types of Sinking Fund Accounts
You should keep your sinking funds in fairly liquid accounts; a high-interest rate money market account is a good choice. The type of account you choose also depends on what the fund will be used for.
If you are working toward a larger goal for several months or years in the future, you may be able to put the money into an account that is not as easily accessible but has a higher yield.
However, you should not put your sinking funds into the stock market. If you want to earn a higher interest on your sinking funds, consider putting them in a savings account that offers a higher interest rate than your local bank.
You may choose to have separate savings accounts for different sinking funds. For example, car repairs may happen at any time, and that money needs to be accessible very quickly. Your down payment for a home does not need to be as liquid since you will know in advance when you will need the funds. This may allow you to earn a higher rate of return on the money you are saving.
Sinking Funds vs. Savings
With your savings account, you are working to build wealth. As you build your savings, it will eventually begin to work for you. You do not want to dip into it.
However, with a sinking fund, you are saving up for your planned expense, which means that money was always intended to be spent. A sinking fund is not likely to increase your overall net worth, but it lets you do the things you want to do, like buy a new car, go on vacation or put a down payment on a home.
Sinking Funds vs. Emergency Funds
Sinking funds are designed specifically for planned expenses. For example, you would use it to replace your roof, since it's likely a known expense. Another planned expense is a vacation. Another expense is a new pair of glasses, if you know that you get a new pair every year, you can plan for them.
However, an unexpected car repair would be covered by your emergency fund, whereas you would use a sinking fund to replace the tires since that is an expected expense.
You may be a pro at padding your emergency fund or sticking to a monthly budget. But adding sinking funds to your financial skill set can help you better manage your money and focus on your financial goals.
Updated by Rachel Morgan Cautero.