What is a Sinking Fund and How to Use One? - How To Budget Now (2024)

What is a sinking fund? It’s a tool to help you stay on track with your debt pay off goals.

Is there a particular item you like to buy or a store you love to shop in all the time?

Are you struggling with impulse buying or paying high interest on large purchases?

Did you know 38% of Americans aren’t saving money because they have too many expenses (Bankrate Survey)?

It isn’t due to the actual debt they have. The real issue is high cost of living and impulse buying.

A sinking fund is the answer to modifying those habits. When I was new to paying off debt, I struggled to stop shopping at my favorite craft store.

I love, love, love arts and crafts.

If I had a bad day, I would walk through the craft store and never left with less than $100 worth of items.

Fast forward to current day, I only spend $100 at the craft store every 6 months.

Sinking funds helped me create the new controlled habit.

What a Sinking Fund Actually Is

A sinking fund is a type of savings account that is meant to be spent with intention.

It is designed to save up for future large ticket purchases to prevent you from using a credit card.

Unlike other savings accounts a sinking fund has a defined ending amount and date.

In other words, sinking funds are a tool to help you stay on track with your budget goals.

Your budget is ready for a sinking fund when you are setting money aside in an emergency fund regularly each month.

As well as, paying off debt consistently.

Example of Sinking Fund Categories

Do not worry about creating the right categories for your sinking funds. This account type is meant to be spent.

You can create an account for anything you like. The only goal is to keep the rest of your debt pay off journey on its current path.

Below are the most common examples of sinking funds.

1. Vacation
2. Large household item purchases such as appliances
3. Vehicle maintenance
4. Christmas / Birthday funds
5. Home maintenance such as a new roof

Just because the above are the most commonly used does not mean you need them.

What is something your current financial life needs?

At the beginning of my debt pay off journey I could not even afford to buy a pair of shoes I desperately needed.

At the end of every month, I only had $10 remaining after paying off debt, living expenses, and setting aside my usual monthly amount into my emergency fund.

My response to that issue was to create a sinking fund for a shoe purchase.

I did not want to create more debt by paying interest on my purchase or sacrificing building my emergency fund.

At that time, I could only put $50 per month in my emergency fund. That’s how tight money was.

Since my contributions were so small the last thing I wanted to do was stop building it.

Again, ask yourself, what does your financial life currently need?

Then build one sinking fund for that one focus.

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Pros & Cons

There are a lot of famous money coaches out there that tell you a sinking fund is a must have in every budget.

However, all personal finance tools have an upside and a downside.

Below I listed the most important pros and cons for you.

Pay particular close attention to the cons.

These will help you decide if a sinking fund is the right choice for your current debt pay off goals.

Pros

1. Can slow or stop impulse purchases
2. You don’t need to empty your emergency fund
3. Save on paying interest for large purchases
4. Spend your money with purpose
5. Earn interest on your savings

Cons

1. Temptation to buy something else before reaching your end goal
2. Does not work for tight budgets
3. Saving money consistently is not a habit yet
4. Could put a lot of strain on your finances

The last con, straining your finances, is the most important measurement for your decision.

If you need to sacrifice saving money in your emergency fund every month to create a sinking fund, then this is not the right tool for you right now.

I didn’t start building my shoe sinking fund until after I paid off 3 of my smallest debts.

Prior to that point, I had more money going toward expenses than what I had in income.

Working up to this point is completely normal.

Sinking Fund vs Other Savings Accounts

Ok, a sinking fund is a savings account with the intention of spending the money in the future.

But how is this different from an emergency fund or a regular savings account?

Why don’t I just use the money from my e-fund or regular savings account for the purchases I want to make?

Extremely valid questions, the answer, so you know when to stop spending.

If you get into the habit of withdrawing funds from your savings or emergency fund every time you want to pay for a vacation, holiday, or large household appliance.

Would you be able to stop before you end up emptying these accounts?

The main idea is to spend with intention. If you take the time to save the money in a sinking fund one of two things will happen.

You will reach your goal, make the planned purchase, and then stop once the account is empty.

Or you will change your mind after deciding the item isn’t as important to you as you originally thought.

You will be able to stop your impulse buys before they happen.

Still not convinced? Let’s take a closer look at the intention of an emergency fund and a regular savings account.

Sinking Fund vs Emergency Fund

An emergency fund is never spent unless an emergency arises. It is also kept in an account that can be reached quickly.

You want transfer of funds to be immediate. You have no idea what you will be spending the funds on in the future or if they will cover the surprise expense.

Your emergency fund is consistently built every month and acts as a safety net for the uncertainty. The goal amount could be anywhere from $1,000 to $5,000.

Sinking Fund vs Savings Account

A typical savings account houses 3-6 months’ worth of your salary in case of job loss.

This is your long-term security blanket. This account is never touched not even for emergencies.

A savings account is also used to collect as much interest as possible over time to make money on your money.

The best way to do this is by keeping it in a high interest savings account.

How Do You Start a Sinking Fund?

Starting a sinking fund is a lot easier than it may sound right now.

Here are 3 simple steps to get you started.

1. Define what you are saving for
2. Identify the ending goal amount and the amount you can save monthly
3. Divide the ending amount by what you’ll save each month. The answer will tell you how long it will take to reach your goal

Do not let your ending date discourage you. As long as you consistently pay off your debt from month to month this date can change.

For example, remember when I was only setting aside $10 per month in my shoe sinking fund?

I actually reached my $60 goal in 3 months instead of the originally calculated 6 months.

How?

I paid off another debt successfully at the time.

I increased my savings goal from $10 to $30 in month two of building my sinking fund.

If I had decided to pay less on my debt to buy my shoes in month one, I would have paid two extra months of interest on the debt I paid off.

I saved money at both ends of the spectrum.

I was ok with starting my sinking fund with small monthly contributions because I was finally stopping the cycle of instant gratification with my impulse buys.

That is what was most important to me.

Where Should you Keep Your Sinking Fund?

I strongly believe in earning money on your money.

I recommend keeping your sinking fund in a high-interest savings account separate from your long-term savings.

You will achieve two goals;

1. Reach your savings goal a lot faster
2. Remove temptation from spending your sinking fund elsewhere.

Especially, if you choose a high-interest savings account at a different bank.

The only accounts I keep at the same bank is my emergency fund and checking account.

Everything else is at a separate bank. Money transfers from my sinking fund and savings account will take 3 days to complete.

The more temptation you remove the more success you will have.

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Concluding Thoughts

Building a sinking fund seems like a fairly simple concept and easy to create.

However, don’t lose yourself in the creation process. I have seen people create 10 to 20 sinking funds but they were unable to reach any of their savings’ goals.

Why, they spread their finances too thin. Only create one sinking fund for now.

Staying focused will help you reach your end goal faster.

I have been creating sinking funds for about 5 years now and never create more than 3 sinking funds in a year.

I also keep my goals consistent. One fund is for vacation, one for holidays throughout the year, and one for yearly expenses.

All 3 of these savings goals are achieved every year.

Stay focused, stay consistent with your current budget goals, and you’ll achieve your sinking fund goal too!

References

https://www.bankrate.com/banking/savings/financial-security-march-2019/