I recently had someone reach out to ask about the best way to save for a couple of large upcoming expenses. In their particular case, they are in the process of saving for a wedding in the next few years, and they are planning some major home renovations in the future too. For most of us, staring down two $20k-30k expenses is extremely intimidating. However, preparing yourself for those large expenses can be much more manageable by chipping away at them over time. This is where sinking funds come in handy.
A sinking fund is an account or pot of money that you regularly contribute to in anticipation of a future expense. To illustrate how a sinking fund works, let’s use the example above of saving for some future home renovations. We’ll assume that the renovations will cost $20,000 and that they’ll need to be paid for in four years. Using a time-value-of-money (TVM) calculator, we can see that in order to save $20,000 in a four-year period, we would need to save about $413 per month.
When Should I Use a Sinking Fund?
Sinking funds work very well for short-term and medium-term goals (not so much for the long-term). If you have known upcoming expenses that are for substantial amounts, you should be using a sinking fund. As I mentioned earlier, items such as weddings and home renovations are certainly deserving of sinking funds. Other popular occurrences that warrant sinking funds are vacations and holiday gifts (Christmas happens the same time every year so there’s no excuse for it “sneaking up on you”). For all of you trying to save a down payment to purchase a house, you might have already created a sinking fund without even realizing it!
Where Should I Keep My Sinking Fund?
Because sinking funds are typically reserved for short-term and medium-term goals, keeping this money safe is a top priority. When safety is a concern, I always recommend a savings account that is FDIC-insured (for banks) or NCUA-insured (for credit unions). Did you notice that I set the annual interest rate to 0.5% in the TVM calculation? That’s because 0.5% is an attainable interest rate for a savings account at the moment. Please do yourself a favor and do not put the money in your sinking fund into a checking account. Generally speaking, checking accounts hardly pay any amount of interest. Even though the 0.5% interest rate for a savings account might not sound like a lot, it’s 0.5% more that 0%!
Since stocks can be incredibly volatile, it would not be advisable to invest a sinking fund in the stock market for an expense that is less than five (or ten depending on your risk tolerance) years out.
Should I Have Sinking Funds AND an Emergency Fund?
Absolutely! It’s important to recognize that sinking funds and emergency funds serve completely different purposes. An emergency fund is (as the name suggests) there for an emergency. It’s there in case you lose your job, have a medical emergency, or in the event that some other unforeseen expense rears its head. On the other hand, a sinking fund is for known upcoming expenses. The difference between the two is the level of anticipation. Sinking funds are for those expenses that you anticipate (such as a down payment on a house) while an emergency fund is to make certain that you remain financially stable when (not if) life throws you a curveball.
Why Is It Called a Sinking Fund?
The term originates from corporate finance, where a bond sinking fund is a pool of money set up by a company with the objective of repaying principal and/or interest to bondholders at a future date. Someone must have decided that the terminology was applicable to personal finance too, as the goal of a sinking fund is to create a way to plan for a future expense. Ironically, by sinking your upcoming expenses like your opponent’s battleship, a sinking fund actually helps you stay afloat!
How we Use Sinking Funds
Nicole and I use sinking funds for a few items, including upcoming vacations and our semi-annual car insurance payments. As I’ve explained in the post about our budget breakdown, we allot a certain amount of money each month to be spent on travel/vacations. If we have any unused amount at the end of the month, it gets rolled over until it gets spent. By handing our travel/vacation expenses in this manner, we have in essence created a sinking fund for these expenses.
Even though neither Nicole nor I drive luxurious cars (read this post to find out what car I drive), our car insurance premiums total about $2,000 per year (thank you Michigan for having some of the highest insurance rates in the country!). Instead of paying monthly, we pay our insurance premiums on a semi-annual basis in order to receive a discount from our insurance provider. That means twice a year we have to fork over nearly $1,000. By setting up a sinking fund for our car insurance premiums, we save a bit each month so we don’t have to scramble when we receive our semi-annual bill.
How do you use sinking funds in your life and how have they helped you?
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