If you’ve ever struggled to save money or keep getting caught off guard by expenses, you’re not alone. According to a CNBC and Momentive survey, 70% of Americans feel stressed about their personal finances, and 58% say they live paycheck to paycheck.
One way to reduce your financial stress and build more of a financial buffer to enjoy life could be to set up sinking funds. A sinking fund often resembles a savings account or emergency fund, except that a sinking fund is earmarked for particular, expected expenses, like vacation or car maintenance.
Erika Taught Me
- Sinking funds can be a good way to organize your savings so you’re prepared for future expenses.
- You can set up different savings accounts as sinking funds, or earmark money within an existing account.
- Sinking funds, though requiring effort, provide security when spending, making the setup and maintenance worthwhile.
What is a sinking fund?
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.
Sinking funds are essentially savings buckets that are 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.
Some people also have emergency funds, which might be used for things like unexpected medical bills or to cover your bills if you lose your job.
But rather than throwing all your extra money into one big pool, you might set up different sinking funds to help you reach specific goals. Unlike many other funds, sinking funds are designed to be drained.
“We all know that big expenses are inevitable, and sinking funds allow someone to save up for a large expense over time. You put a certain amount aside — each month, or as you're able — for whatever future expense you want to save for. Then, when that expense comes up, you pull the money you need from your sinking fund,” says Elizabeth Pennington, a certified financial planner and senior associate at Fearless Finance.
Some sinking funds are used for known expenses, like if you’re saving up to buy a particular car. But they can also be used for inconsistent expenses, like housing repairs. While you don’t know exactly how much you’ll need and when, you might put aside, say, $500 per month to use whenever housing expenses come up.
Pros of a sinking fund
Sinking funds can help your financial and personal life in many ways. Some of the top benefits of sinking funds include:
Staying 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 and stay on track if that money gets mixed in a general account. Separating your finances with sinking funds and specifically adding money to those funds can help you reach your goals.
“If you are diligent and disciplined in putting money away systematically, you’ll have the funds needed for that special item sooner than you know it. And, you won’t have disrupted your other important financial priorities,” says Brandon Robinson, president and founder of JBR Associates.
Avoiding debt
If you have money set aside in sinking fund accounts for things like car maintenance or home repairs, you might be able to avoid going into debt to cover these expenses.
“Instead of having to hit your credit card for that next major expense, if you have a sinking fund set up, you may be able to tap into it to cover it fully,” says Jordan Gilberti, certified financial planner, and senior lead planner at Facet.
While your emergency fund could also potentially be used to avoid debt, you might prefer to keep your emergency fund intact in case you have a period without income. Sinking funds, on the other hand, can be used to build up pools of money for areas that you generally know you’ll need, even if the specifics vary.
For example, you might look at the average annual maintenance costs for the type of car you have and set up a corresponding sinking fund.
Gaining 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.
“Psychologically, they also help you feel more prepared for bigger things coming down the pike. Suddenly needing a new car, or a major home repair, or surgery for a pet can be really stressful, and we don't want financial stress to compound that,” says Pennington.
Cons of a sinking fund
As helpful as sinking funds can be, there are some potential downsides, such as:
Distracting 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 sinking funds. In most cases, contributing to emergency funds is a more important goal.
“If you are ‘sinking’ money into savings for an item you really don’t need, then you may be neglecting other important financial goals. Don’t take away from your investments or emergency funds in order to build a sinking fund,” says Robinson.
Carrying opportunity costs
Similar to the problem of distraction, 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.
“There's opportunity cost to everything we choose. If you have too much in sinking funds, you might be losing out on investment returns or might not be able to appropriately prioritize other big financial goals like retirement,” says Pennington.
Adding complexity
While sinking funds can reduce financial stress in the long run, they do require some upfront effort. You need to create sinking funds either with a dedicated savings account for specific goals or smaller cash envelopes. Sinking fund contributions also requires some planning to balance monthly expenses and other financial goals like growing your savings account.
“Overall, having a sinking fund can make your budget a little more complex. This added complexity can create some extra work that you may or may not want to take on,” says Gilberti.
Related: How many bank accounts should I have?
Examples of 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 Robinson.
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 Gilberti.
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 use physical envelopes, while apps offer digital alternatives for organizing money, making it convenient in today's digital age.
Related: Best high-yield savings accounts
“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.
“If you're saving for something in the short-term, you should prioritize an FDIC-insured account earning at least some interest,” says Pennington.
Consider diversifying sinking fund money across various accounts, not limited to traditional or high-yield savings accounts.
For example, if you already have enough saved up for a future expense and want to avoid draining it early 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.
Should you use sinking funds?
Overall, sinking funds help organize finances and achieve goals. 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,” she adds. “However, visualizing the sinking funds as separate priorities can help you stick to those goals better, so the ‘mental accounting’ works in your favor.”
Similarly, a general savings account might work for some people when budgeting for fun expenses like trips. Others, however, prefer the categorization and discipline that can come with using sinking funds.
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.
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