Sinking Funds: What They Are and How to Use Them

What would you do if your car broke down? You still have to get to work but the car needs to be fixed.

Do you pay for the repairs with your emergency fund? Do you use your credit card and hope there’s enough money to cover the bill when that is due?  Or do you already have savings set aside for car repairs? After all, cars do need to maintenance and repairs from time to time.

It’s times like this when having a sinking fund can save the day.

I will fully admit that while I knew the concept, I hadn’t heard of the term “sinking fund” until a couple years ago. This budgeting concept is not only easy to learn, but an essential tool to have in your money toolkit.

What is a sinking fund?

In personal finance, a sinking fund is a fund created to save money for specific purposes. You can even think of it as a bunch of savings buckets.

If you have a savings account and emergency fund, then you might wonder what the purpose of a sinking fund is.

Rather than save money in one large savings account for emergencies and vacations and gifts and taxes and whatever else, sinking funds allow you to save with purpose.

By saving money this way, you are actually giving yourself permission to spend! It’s a great way to plan your budget goals for the long term.

What’s the difference between an emergency fund and a sinking fund?

You might be wondering what the difference is between sinking funds and an emergency fund.

An emergency fund is savings you set aside for emergencies – unexpected and unplanned expenses.

Unexpectedly lose your job and need money to pay the bills until you find another job? Emergency fund. Did your child break a tooth at the hockey game? Emergency fund.

A sinking fund is money set aside for planned and predictable expenses. This might be saving up for a new(er) car, braces, a vacation, or a new sofa. These are expenses you can anticipate and plan for.

Why do you need sinking funds?

I’ve talked before about how setting aside money in multiple accounts, or money buckets, gives you a psychological edge.

It acts as a commitment device. Basically, the mental accounting you do with separate money buckets feels very different than if all your money is in one bucket, at least when it is time to spend the money.

For whatever reason, having a large savings account and seeing the total drop $10,000 when you replace the roof feels different than if you take $10,000 from a “new roof” sinking fund. The sinking fund gives you permission to spend the money guilt-free because it’s easy to see you are still saving towards other goals and paying down debts.

A sinking fund allows you to:

• Plan for the future Make room for your lifestyle by giving your money a job. You can get a new car, plan a vacation, or remodel the basement. You can be proactive with your savings rather than reacting with your spending.
• Lose the stress when spending Sinking funds allow you to plan your spending ahead of time. When you’ve saved enough toward your goal, you can spend the money guilt-free.
• Spread expenses out Monthly contributions to your sinking funds helps you gain control over your money and spreads out the expenses over a longer period of time (vs. coming up for the money all at once)

How do you set up a sinking fund?

Ready to set up sinking funds? Great!

In general, you’ll want to keep your sinking funds liquid (which is fancy-speak for readily accessible). This means that a bank savings account is a great place for a sinking fund, especially high-interest savings or money market accounts.

Why high-interest? If you have your money at a standard big-name bank, you are earning maybe 0.02% interest. How anemic is that?

At many online banks you can find savings and money market accounts yielding 100x that amount or more! (Really, I just compared the bank that holds our mortgage vs our online bank. It was 0.01% + fees vs. 2% and no fees.)

What you shouldn’t do is put money for your sinking funds into investments. Investing is a long-term proposition and you risk losing some money in the short term.

To set up your sinking funds, you’ll want to create multiple subaccounts or named savings accounts (my preference). Many banks let you do this easily online and won’t charge a fee.

Another option is to set up one savings account and then use a spreadsheet to track how much money is in each fund. Personally, I’m a fan of the psychological framing provided by separate accounts.

What would a sinking fund setup look like?

Let’s say you already have $10,000 in savings. You might break it down into separate accounts or spreadsheet line items such as:

• Emergency savings: $5,000
• Vacation: $500
• Car: $2200
• Home repair: $600
• Life insurance: $400
• Gifts: $300
• Technology: $200
• Taxes: $800

Each month, you’ll deposit money into your sinking funds. You can do this manually or you can set up automatic transactions.

Once you’ve saved enough in the fund, you pay the bill/buy the new gadget and begin saving again.

How much should you put in a sinking fund?

Ok, so how much do you contribute to the sinking funds? Once you decide on the sinking funds you want to set up, then it’s just a tiny bit of math. The math all depends on when the expense will occur and how much it will cost.

Let’s say you want to replace your dishwasher within a year and are comfortable with models that are about $600. Depositing $50/month for 12 months to the “dishwasher” sinking fund ensures that $600 is already set aside for the purchase.

Then you go through and do this with each sinking fund, balancing what you need to save with what your budget allows you to put into your sinking funds each month.

Once you’ve reached your savings goal in the sinking fund, you can spend the money, or stop saving and direct money in your budget into another sinking fund. You have the money set aside for a new dishwasher, but you don’t have to buy one yet if the old one is still going strong.

What sinking funds should you have?

Personal finance is, well, personal so items in your budget will be specific to you. Here are some ideas to get you started:

• Life insurance premiums
• Car insurance premiums
• Vacation
• Property taxes
• Gifts
• Car repairs
• Garden
• Wedding
• New phones
• New computers
• Home repair
• Hobby supplies
• Season tickets to ____

These are just a few ideas to get started. You probably have a few ideas floating around as well.

What to watch out for with sinking funds

This all sounds great, but what are some gotcha’s when it comes to sinking funds?

If your bank is charging you fees to have the accounts or makes you jump through some hoops like requiring a dozen debit card transactions every month, it’s time to find another bank.

Another thing to be careful of is to not treat your sinking funds as general spending account. If you are saving for a dishwasher, then it’s not okay to take money from the dishwasher fund to have a pizza party.

It’s also best to not use sinking funds for long-term savings like retirement or your children’s college fund. There are better ways to save for those goals.

Nor is it wise to use a sinking fund for emergencies. Before starting sinking funds, you should have a good start on an emergency savings account.

Final thoughts

Start with a couple sinking funds to start and build up from there.

Sinking funds can change the way you manage your money for the better by focusing your financial goals.