Don’t let the name fool you! Sinking funds typically don’t drag you down. Instead, with proper preparation, they can float you through almost any expense in life.
A sinking fund is similar to an emergency fund, except that a sinking fund is earmarked for particular, expected expenses, like a vacation or buying a new car.
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What Is a Sinking Fund?
Sinking funds are essentially savings buckets that you set up to cover specific types of spending.
Normally, you might put any leftover money from your paycheck into a savings account. Then, you might dip into those savings anytime you have extra costs, like if you’re booking a plane ticket or want a new iPhone.
Unlike many other funds, sinking funds are designed to be drained.
“You put a certain amount aside — each month, or as you're able — for whatever future expense you want to save for,” explains Elizabeth Pennington, a certified financial planner and senior associate at Fearless Finance.
“Then, when that expense comes up, you pull the money you need from your sinking fund.”
Some sinking funds are used for known expenses, like if you’re saving up to buy a new car.
But they can also be used for inconsistent expenses, like housing repairs. Maybe you don’t know exactly how much you’ll need or when, but you put aside, say, $500 per month to use whenever housing expenses come up.
Pros of using a sinking fund
Sinking funds can help your finances in many ways:
- Stay on track for financial goals: If you know you want to save up for a big purchase, like a new car, a down payment on a house, or a trip to Europe, it can be hard to track your progress if that money is mixed in a general account.
- Avoid debt: If you have a sinking fund for things like car maintenance or home repairs, you might be able to avoid going into debt to cover these expenses. While your emergency fund could also be used for this, you might prefer to keep your emergency fund intact in case you have a period without income.
- Gain peace of mind: By earmarking funds for particular types of expenses, you may be able to relax more, knowing that you can afford whatever you’re saving for.
Cons of using a sinking fund
However, sinking funds can also get in the way of your longer-term goals.
- Distracts you from more important financial goals: While it’s nice to save for new clothes or a luxury car, you might not be ready for these purchases, even if you’ve saved for them. In most cases, contributing to emergency funds and investing long-term is a more important goal.
- Opportunity costs: Sinking funds can cause you to miss out on other opportunities, like letting your money grow over time by investing it in the stock market.
- Adds complexity: Sinking funds require some upfront effort. You need a dedicated savings account for specific goals or smaller cash envelopes. You also need to balance monthly expenses and other financial goals like growing your overall savings.
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How To Use a Sinking Fund
There are many ways to use a sinking fund. The beauty is that you get to choose what to save for and how to spend it!
Some examples of how to use a sinking fund include saving for:
- Vacation
- Home down payment
- New car
- Car maintenance
- Home maintenance
- Pet care
- Wedding
- Gifts
- Medical care
- College
“The ideas for a sinking fund can be endless — as long as it meets a certain need at a specific timetable,” says Brandon Robinson, president and founder of JBR Associates.
Create sinking funds based on financial goals and the status of your savings and emergency fund. Whatever you choose, be sure to attach a specific number to it and save it accordingly.
“For example, if you know that in 12 months from now, you want to take a $3,000 family vacation, you can set up a specific bucket of money that you add $250/month into so you know it will be filled by the time you want to book your trip,” says Jordan Gilberti, certified financial planner and senior lead planner at Facet.
How To Create a Sinking Fund
Sinking funds also have some flexibility in how they’re set up. Some people choose to actually open separate savings accounts for each sinking fund/goal, but this can get a bit overwhelming if you have too many sinking funds.
Another approach is to use the envelope method, where you put money into different envelopes for different expenses. Some people use physical envelopes, but there are also budgeting apps that do this digitally.
“A great way to set up a sinking fund is to utilize the tools at your existing bank. Some of them may even offer the ability to ‘bucket’ your savings into different categories, thus creating virtual sinking funds for you that you can automate,” says Gilberti.
Plus, keeping funds in a bank account can be safer than an envelope.
Just make sure you're putting the money into an account that earns you interest. High-yield savings accounts (HYSAs) have APYs well above the national average, so you can grow your sinking fund a bit faster.
For example, the SoFi Checking and Savings Account earns a base rate of up to 3.30% APY, plus a six-month boost of 0.70% on new accounts (terms apply.)* SoFi also offers “vaults,” which let you set specific savings categories without having to open another account.
You could also diversify your sinking fund money across various accounts. For example, if you already have enough saved up in an HYSA and want to avoid draining it, you can create a sinking fund with a certificate of deposit (CD).
“A higher-interest-paying CD could be a good idea. If you need the money in three- or five-years, then open a 3-year or 5-year CD,” says Robinson.
Because CDs generally carry penalties for withdrawing funds early, that could incentivize you to leave the money in place.
RELATED: How Much Should I Save Per Month?
FAQs
What is the difference between a sinking fund and a savings account?
A sinking fund is a way to bucket money for a particular expense, and it’s designed to be drained. A savings account is a versatile fund for growth, not to be completely depleted but maintained.
How much should you keep in a sinking fund?
The answer depends on what you’re using a sinking fund for. Some people might have small sinking funds, like putting away $100 to use for a party. Others might have large sinking funds, like saving $100,000 for a down payment on a house.
The structure of the accounts might differ based on your goal, as you probably wouldn’t want to keep $100,000 in cash in an envelope, for example.
Are sinking funds a good idea?
Sinking funds help organize savings and provide comfort for spending once enough is set aside for a specific expense.
TL;DR: Should You Use Sinking Funds?
Sinking funds can help you organize your finances and achieve your goals. But if you're already good at saving and comfortable allocating funds, sinking funds may be unnecessary.
“At the end of the day, a healthy emergency fund may be an appropriate alternative as well because there's a level of artificial ‘mental accounting’ happening with sinking funds,” says Pennington.
“Picture this: you have a lot of money in a sinking fund for a new roof, but then you suddenly need a new car. Most people are going to pull money from that sinking fund for the car, so it's essentially the same effect to have a bit more ‘slush’ money in your emergency fund.”
But if you like the categorization and discipline that can come with using sinking funds, they may be ideal for you.
“Visualizing the sinking funds as separate priorities can help you stick to those goals better, so the ‘mental accounting’ works in your favor,” says Pennington.
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