Sinking funds: What they are & why they're important
When we build a budget there are expense categories such as housing, auto & transport, dining, entertainment and so on. We spend money on these categories each month, which is why they're in our budgets every month.
A budget should also have categories for extra debt repayments (especially if you have any debt above a 5% interest rate) and savings! How much you should be aiming to save each month will be dependent on your goals and what you actually want to save for. The things that you are saving for become your sinking funds.
What is a sinking fund?
It sounds like a pretty odd term, right? "Sinking fund". Sounds like where you send your money to drown. Well if you thought that, you're not completely off the mark. Hear me out.
By it's true definition, a sinking fund is:
a fund formed by periodically setting aside money for the gradual repayment of a debt or replacement of a wasting asset.
Most of us would recognize a car loan as a type of sinking fund by this definition, as it's a depreciating asset that loses value over time. While this is true, in the personal finance community sinking funds are more typically used to describe saving for a particular planned expense, such as a vacation, house deposit, car purchase, etc.
So if we were to redefine the term "sinking fund", it would be more like this:
a fund formed by periodically setting aside money for a future planned expense.
The more common fund type you may have heard of would be the "emergency fund", which is a stash of cash nestled away just in case something unforeseen comes up, such as a job loss, unexpected car repair, etc. The emergency fund is for unplanned expenses whereas a sinking fund is for planned expenses.
Why sinking funds are important
Knowing the rough cost of what we want to save for allows us to break up the total amounts into manageable monthly chunks that we can work into our budget. For example, say we are saving for a weekend away that we think would cost $1000 in total and it's 4 months away. We would want to put $250 away each month to achieve that savings goal. If you're paid twice a month, $125 each pay.
$125 a pay over several weeks is much more palatable than one big whack of $1000. Saving for these expenses each pay makes it much easier than just trying to "come up with the money" the with week of. This is why setting up sinking funds for all of your larger, planned expenses is a powerful way to achieve your savings goals.
Where to keep your sinking funds
Arguably the best place to set up your sinking funds is in a High Yield Savings Account (HYSA) with an online bank. Since we live in Canada, our online bank of choice is EQ, which currently offers us 1.7%. While that's not huge, it's much larger than the typical 0.06% offered by your typical brick and mortar banks.
Earning a few extra dollars for just having your money deposited is a no-brainer. Find an online bank with a high APY (Annual Percentage Yield) with low or no fees and get an account set up if you haven't already.
I'd recommend setting up savings accounts for each of your sinking funds, ideally within the same online bank account, so it's easier to keep track of which one is which. To personalize them even further you can usually name your accounts so that way you'll know which sinking fund is what.
Once your accounts are set up, figure out how much to send to them each time you get paid and then transfer the predetermined amounts every pay cycle. If you can set this up to happen automatically, even better!
Most popular categories for sinking funds
While you could make a sinking fund for just about anything you'd like, these are the most popular ones:
Christmas gifts - it comes around every year, so why not save for it throughout the year?!
Car purchase - avoid going into debt to buy a car by saving for it and using your own money.
House deposit - probably the biggest savings goal most will have. Start this one at least a year out from when you plan to buy a house, ideally even 2 or 3 years.
Vacation - who doesn't love a good vacay?
New purchase (phone, laptop, furniture, etc.) - plan it in to avoid one big lump sum hit to your wallet.
Anything you want!!
Planning in your larger expenses with the use of sinking funds will make paying for these expenses a whole lot easier than just trying to cough up a lump sum the day of the event or purchase. Putting money towards these goals each and every time you get paid will ensure there's no big surprises to your budget and wallet when it comes time to make your purchase or spend the money.
As always, we appreciate any feedback you have on this and other topics we write about. So if you have any thoughts or comments be sure to let us know. We appreciate it!
Blake - FIRE with a family