Sinking Funds 101: What, Why, and How
Creating a budget for monthly expenses is easy, but it’s often non-monthly surprises that break the bank. Ever been surprised by a $500 car insurance bill or your annual Amazon Prime subscription? If the answer is yes, a sinking fund is the answer.
Sinking funds are your ultimate ally in tackling non-monthly expenses.
What are Sinking Funds?
At its core, a sinking fund is a strategic savings tool wherein you set aside a fixed amount of money regularly to anticipate and cover non-monthly expenses. These expenses might not occur monthly, and while some are predictable, like insurance premiums or annual memberships, others are coverage for those “just-in-case” moments that always seem to come up.
Sinking funds are a critical aspect of financial planning and health because they are what protect you from taking on expensive credit card debt when the unexpected occurs.
Common Uses of Sinking Funds:
Vehicle Maintenance: From routine servicing to unexpected repairs, a sinking fund cushions the blow of automotive expenses. At minimum, you know you need to get your oil changed twice per year, so plan for this!
Home Repairs: Whether it's a leaky roof or a malfunctioning appliance, a sinking fund ensures you're prepared for household maintenance costs. Maybe you don’t know what you will need to pay for yet, but you know it’s going to happen, so it’s prudent to set aside some money each month for the inevitable.
Insurance Premiums: Annual or semi-annual insurance payments become manageable with a dedicated sinking fund. These are some of the easiest sinking costs to predict, and you know which month they’ll land in!
Medical Expenses: Covering medical bills and prescription costs becomes less daunting when you've planned ahead. Pro tip: You can use a health savings account (HSA) as your medical sinking fund, and fund it with pre-tax dollars!
Vacations: Save up for your dream getaway without compromising your financial stability. Know you want to go on vacation twice this year? Have some weddings or bachelorette parties in your future? Guesstimate how much these will cost (googling flights and hotels is easy) and then set aside an amount monthly to fund your future fun.
Gifts: Budgeting for birthdays, weddings, and festive seasons becomes hassle-free with sinking funds. This is another example of a fund that requires you to set the budget vs. being told by a bill.
Subscriptions: Annual subscriptions like Amazon Prime can be funded effortlessly through sinking funds. Same story for your annual credit card membership fees, or any other membership you pay on an annual basis.
Determining the Amount to Set Aside:
The math here is simple: Calculate the total cost of the anticipated expense and divide it by the number of months until payment is due. This simple formula ensures you allocate a manageable sum each month towards your sinking fund, preventing financial strain when the expense arises.
For example, if you know you will need to pay $500 twice per year for car insurance, that’s $1,000 divided by 12 months, or $83.33 per month that should be allocated to your sinking fund.
If it’s January and you and your friends are planning a trip for Memorial Day weekend, you know you have 5 months to save for the trip. You know flights cost $500, and hotels will be about $200/night for 3 nights, and you budget $150/day for food and entertainment. The total cost of the trip is then $500 + $600 + $450 = $1,550, which means you’ll need to save $310 per month to fund this trip.
Setting Up and Tracking Sinking Funds:
There’s no one best way to manage a sinking fund. Just like a money plan, that best plan is the one that works for you!
Here are some ways you can implement sinking funds into your process:
Separate Accounts: Some prefer maintaining separate savings or checking accounts for each sinking fund, offering clarity and organization. Each month, you set an auto transfer for the amount you want to save into the fund. Having multiple accounts might be confusing, so instead having one that is a catch all for all sinking funds (which would be a total of all of your monthly savings for these unexpected expenses) could be a good fit.
High-Yield Savings: For larger expenses, like house maintenance or big trips, consider saving in high-yield accounts to maximize interest earnings.
Budgeting Apps: You don’t need multiple accounts to track your various funds. Utilize a budgeting app like Habit Money or YNAB, or a spreadsheet to track how much you’ve contributed to each goal. Create individual categories for each sinking fund, track contributions, and monitor fund balances effortlessly.
Incorporating sinking funds into your financial arsenal is akin to fortifying your defenses against unexpected expenses. Say goodbye to the stress of the surprise charge on your credit card! With sinking funds, you’ll be ready for whatever expenses come your way.
Feeling overwhelmed with this approach and want some help getting started? Schedule a free call with one of our Habit coaches today!
