What is a Sinking Fund and Why It’s Needed
You planned on going for a vacation at the end of the year. Excited by the thoughts of long lazy days spent on an exotic beach surrounded by beautiful, happy people: you can hardly wait. However, there’s a small problem – vacations are expensive. Where will you get all that money? Certainly, it would deplete your savings, which you have been building up for some time now. There has to be another way. Enter the sinking fund.
Suddenly, a flash of inspiration strikes you. You could take out something from your paycheck every month! So that by December, you will have your vacation money ready without having to touch your life savings or emergency funds! Brilliant!
You slap yourself on the back, considering yourself a genius of sorts.
Well, you might be a genius, (at least your mom thinks so), but the idea of setting money aside for a specific purpose in what is known as a sinking fund, has been around since the 14th century when wise Italian public officials used it to retire redeemable public debt.
And What Exactly is a Sinking Fund?
It is a saving plan where you deliberately set aside some money periodically and regularly to help you pay for a specific expense in the future. It can be applied by individuals and businesses alike for things like:
- Buying a new car or machinery
- Capital expenditure
- Christmas present
- Making property tax payments
- Buying back bonds
- Settling debts etc.
When you move money into a sinking account monthly or weekly, you are equipping yourself for when you have to make the more significant expenditure. You won’t have to dip into your emergency savings or, most importantly, incur debts.
In personal finance, a sinking fund is an underrated safety net. It keeps you from sinking in debts, helps you stay within budget and on track to achieve your financial goals.
How does it work?
Assume you have 3 major expenses you have planned to save up: a vacation, a new car, and down payment for your home.
First, start by estimating the cost of each expense and when it will be due. Then, crank out your old calculator and determine the monthly amount you wish to save for each expense item.
You should have something like this:
|s/n||Expense Item||Cost ($)||Time (months)||Monthly Saving ($)|
|3||Down Payment for a Home||24,000||24||1,000|
Once you get the monthly savings for each expense, build them into your budget, and set-up automatic transfers to your sinking fund account.
That brings us to the next logical question.
What types of accounts can you use?
You’ll need a reasonably liquid account such as a money market account, or savings account to warehouse your sinking funds. The account should be specified for this purpose. The idea is to keep this money separate from your other accounts, so you know exactly what is available to spend for your intended purpose.
The type of account that you will open is also determined by the purpose of the funds. If you are saving for the long-term, choose an account with high yield that is not easily accessible. A short term saving will be fine in a regular savings account.
Avoid putting your money in the stock market, but rather shop around for high-interest rate savings accounts which may not be obtainable in your local bank.
Sinking fund vs. savings account
The difference lies in the intention. A sinking fund account allows you to save for planned spending safely. That is, the money you are saving was already scheduled to be spent. But with a savings account, you are seeking to grow your wealth. As you add money to your savings, it works for you to increase your wealth based on the principle of compound interest. You do not want to have reasons to dip into it every now and then.
A sinking fund may not directly increase your total net worth, but it gives you room to do the things you want to without it affecting your nest egg. You can go on a vacation, pay for a home, or buy a new car guilt-free.
Sinking fund vs. emergency fund
With a sinking fund, you already know the expense you intend to use it for. Costs like a vacation or Christmas gifts are already known. Therefore, you can plan for them. But emergency funds are meant to cover unexpected and unplanned events. These include medical emergencies, vehicle repairs, and some home repairs. This helps you to avoid spending money that you can draw on in case of an emergency for known recurring expenses. This will help you focus on your financial goals and stick to your budget.
Let’s look at some which will help you live the kind of life you want:
- For house emergencies: as a homeowner, nothing is more annoying than having your heating system develop a fault. Or a leak is springing up somewhere in the plumbing. And it sucks, even more, when it happens at an ill-opportune moment; when you are about as liquid as Job’s butler. So, what to do when you are hit with an unexpected repair that is not covered by insurance, and you don’t have any readily available cash? Raid your emergency savings? Pay with plastic and raise your debt profile? A house sinking fund will mitigate such (inevitable) situations. Start by identifying the likely parts of the house that may need repairs and estimate how long they will currently last before needing attention. Emphasis should be on valuable items that are not covered by insurance. Then get an estimate for their repairs or replacement. With the total, you can then determine how much you can set aside from your paycheck each month which provides a comfortable buffer for when things start to fall apart.
- For a Wedding: weddings can be expensive. Whether you are the one getting married or your best pal from high school. That said, it’s no excuse for you to avoid getting hitched. You can make it easier for yourself by putting money aside to take care of accommodation, fancy dresses, diamond rings, gifts, and more.
- For a Car: this can help you in two ways – to fund the purchase of a car and to fund insurance premiums, gas, servicing, and other costs involved in running a car.
For instance, if you decide on a white Camry 12 months from now and the cost of the car is $12,000. You can immediately start dumping $1000 monthly into your car sinking fund till you hit the $12,000 mark. You may then proceed joyfully to the dealership.
- For furniture: Sofas get worn and TVs outdated. To replace such costly furniture, consider a furniture sinking fund. Since you already know they need to be changed, you’ll have had enough time to build up the sinking funds for that purpose. You can then enjoy the breath-taking panorama of your new 55-inch curved HD TV without guilt or incurring debts.
- For Christmas gifts or Holiday expenses: Few traditions are as strong as Christmas. And gifts are sacrosanct. However, those prettily wrapped boxes could put a hefty dent on your finances. And God bless you if you come from a large family. It is intended to warm the heart of your loved ones at Christmas is just what you need. Having to plan well in advance for gifts will enable you to carefully consider what you intend giving for Christmas and avoid being lured in by clever advertising and marketing by holiday retailers.
Why you need a sinking fund
If you analyze your spending pattern over time, you’ll be surprised at some particular expenses which come up regularly and significantly affect your budget.
Also, pay attention to the stuff you had to pay for with your credit card, not because you like debt, but because you were unprepared for the expense.
These costs will always come up in the natural course of events. Therefore, you must develop a strategy for taking care of them without depleting your savings or going into debt.
Sinking funds will help you:
- Save for any purchase or expense. Just be specific and intentional about what you want and save towards it.
- Enjoy your money without guilt. Take that dream vacation or splurge on a BMW touring bike without any regrets. Just because you made provisions for them in your budget and channeled your money appropriately.
- Prepare for the unexpected. Peace of mind by simply knowing that you have prepared for eventualities. You may never know what will fall apart, break, or find another way to disappoint you. But that these things will happen is not in doubt. Saving money over time for such unexpected events will make fixing and repairing the situation a lot less stressful.
You need to start saving in a sinking fund if you are always running around in a panic whenever a regularly occurring bill comes up. And no, whipping out your credit card every time is not a solution.
After the initial hassles of setting up and automating transfers to them, you will find it highly beneficial in the long run. You can now meet your financial goals easily and with less stress.