Sinking Funds: Are they necessary?
What exactly is a sinking fund and is it really an important part of my overall financial plan?
“What exactly are sinking funds and should I be using one?”
Quick Answer
Sinking funds are savings accounts that are earmarked for a short-term goal and you contribute little bits each paycheck.
How is that different from a regular savings account?!
Well, it’s not, really, it’s just a fun twist. Your general savings account, like an emergency fund, might just be there as a safety net. The sinking fund is set aside to be spent on something specific.
Detailed Answer
Common sinking fund examples would be for buying gifts at the holidays or back-to-school shopping or your partner’s birthday. You know it’s coming every year, so you should be proactive about financially preparing. You might also have a sinking fund for a piece of furniture you want to buy or a vacation you want to take.
For example, let’s say $600 is my budget for Christmas gifts. Instead of scrambling in November or December and trying to shoehorn that cost into my monthly budget, I can set aside $50 per month starting in January in order to have a “sinking fund” for Christmas gifts.
When creating a sinking fund, it’s important you have a deadline and a financial goal. To continue on the Christmas example, let’s say December 15 is the deadline (we want to be buying gifts before the holiday) and $600 is the financial goal.
If you start on January 1 of that year, it means you have 12 months to achieve your goal.
$600/12 = $50 per month.
The closer you are to your goal (e.g. October 12 for a December 15 goal) means you have to save a lot more to achieve the same feat.
$600/3 months = $200 per month
When there are specific events that happen annually like birthdays, necessary travel, holidays, then it becomes easy to routinely have a sinking fund for those expenses. The same can be done for annual expenses like insurance policies. Personally, I had an “other people’s weddings” sinking fund for most of my twenties and into my early thirties. Even before invites came in, I had money set aside for the cost of attending weddings.
The ultimate point of sinking funds is to prevent you from skimming out of other accounts, like emergency savings, when you find it tough to cash flow the cost of something into your regular monthly budget.
Bonus tips:
Credit card rewards: I save up all the rewards on two of my cash back credit cards to subsidize my Christmas budget! It’s a totally passive way to have a little extra money and it’s especially helpful if there’s a particularly expensive gift I want to give – or even buy myself (hello orchestra seats to a Broadway show). Just make sure you don’t end up in credit card debt chasing rewards because that completely negates the benefit!
Nickname your savings account: It sounds hokey, but it’s helpful! Most banks and credit unions will allow you to change the generic account number (e.g. Account 9389128) to something specific like “Japan Trip July 2024” or “Down payment summer 2026.” The more specific you can get the better. Having your accounts nicknamed help serve as a visual reminder of why you’re saving and might deter you from siphoning off little bits here and there when you want something today.
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Great way to think about saving for a specific goal-- makes it feel much more real.