Have you ever trained for a marathon? For a beginner who hasn’t done it before, this can look like an impossible task. It can be very discouraging when you are unable to break up your practice sessions into small “meaningful milestones.”
If you were to run a marathon, you don’t want to be sprinting your way through it. When you know in advance that you need to preserve your energy till you cross the finish line, you’d want to pace yourself accordingly. Doing so allows you to not only pass the finish line but also do it in a way that doesn’t make you hate marathons!A sinking fund is somewhat similar to how an athlete approaches a marathon. It lets you tackle a big problem by breaking it up into small manageable chunks. Click To Tweet
Today’s let talk about the sinking fund. Let’s try to understand what a sinking fund is, how it’s different from other types of funds you come across in personal finance, when should you use it, how much do you need to save in a sinking fund, etc. Let’s take a deep dive to explore what this fund is all about.
What Is A Sinking Fund?
A sinking fund is basically a fund that you set up to meet a known expense that is expected to happen sometime in the future. You have a good idea about when this expense will occur, and hence you are not in a rush. You have time to save for it over some time which can range anywhere from 6-24 months or even more.
We all have expenses that could be lurking around the corner to catch us by surprise. If you have been in debt before, you might agree that going into debt to meet such an expense isn’t a very desirable thing to do. It keeps you bound to the cycle of debt. Is there a better way to handle such known expenses without going into debt?
A sinking fund is your answer to tackling significant known expenses in small affordable chunks, one step at a time. It’s almost like “dollar-cost-averaging” your retirement savings.
How Is It Different From Other Funds?
Now that you know what a sinking fund is, you might be thinking how different is this from your emergency fund or a regular saving fund.
This is a very fundamental question one might have, and I wouldn’t be surprised it popped up in your head too. I felt the same way when I first heard of it. But here’s the deal. Although it looks very similar to a “savings account” due to the savings aspect of it or an “emergency fund” because it helps cover an expense, it is still a different fund. Let me explain how.
1. Regular Savings Fund
When it comes to a regular savings account, I primarily view this as part of the liquid asset. It’s very much part of my wealth building plan, but I don’t have it earmarked for any specific purpose.
An excellent example of why anyone would have a regular savings account might be giving some the comfort of knowing that if there an investment opportunity that comes along like a bear market or a new real estate investment, it can be convenient to have some cash ready for use.
To that end, I don’t treat a regular savings account as a sinking fund. Although it can be built up similar to a sinking fund, there is not a definite purpose attached to it. It’s a fund that can give you comfort knowing your liquid assets are not nil and all of your money is either locked up in retirement or investments in the stock market or in real estate.
2. Emergency Fund
A lot of people would argue that an emergency fund is very similar to a sinking fund and what’s the necessity to have another fund. But all those arguments don’t hold ground since a known expense in the future is not an emergency. It’s definitely possible to plan for it, if you really want to.
However, if the expense that was supposed to occur a year from now got advanced to a closer date, and was critical, I would then and only then consider it as an emergency. For all other purposes, it is not an emergency, it’s a known expense.
To that end, I would never tap into my emergency funds to meet such an expense. If you look at it another way, having this mindset, really makes you discern a known expense from an emergency. This is a good thing since you’d not be tempted to deplete your emergency fund, every time there is an expense, and you can’t come up with cash to pay for it.
If you are disciplined enough to watch your finances, budget your money, care enough to not go into debt, I believe you’d be well served to treat this as a separate fund. Leave the emergency fund alone and don’t confuse it to a sinking fund.An emergency fund should be used in to cover emergencies only and nothing else. It lets you sleep well at night, knowing that any unforeseen expense will not throw you off balance. Click To Tweet
How Does A Sinking Fund Work
Now that you know what a sinking fund is and how it’s not the same as your savings fund or an emergency fund, you might be curious to know how it works. How to go about calculating how much you need for a sinking fund. Let’s dive right into it.
Let’s say for example, that you plan to purchase a car and your present car is getting costlier to maintain due to all the repairs. The maintenance costs far exceed the value it could fetch if you were to sell it. So you have been seriously considering purchasing your next car.
When you are in a scenario like this, you would typically consider one of the following options.
- Sell your car as is and use the proceeds to buy a new (or used) car. In this case, you would have to pay for the difference immediately. You could cover the difference by going into debt. It’s what most people would do. I would advise you to not do it.
- Save the amount you’d need to buy the car over a period of 12-24 months and have the cash ready. When you sell or trade in your car, you don’t have to finance it. You just pay cash for it and it will allow you to stay debt free and own your car, free and clear.
I sincerely hope you chose option #2. As someone who was in debt and paid off both 2 car loans, I know how it feels to have a car payment. I simply didn’t feel it was the best financial decision I’ve ever made. It felt as if my cash flow was hijacked by these payments and paying interest on my auto loan was no fun either.
Besides, I don’t want to make a payment every single month towards something that is going down in value. It’s not an asset, it’s a liability. Add to it the cost of insurance, fuel expenses, and periodic maintenance, your costs will soon add up substantially.
If you find yourself in a situation like this, I will encourage you to be pro-active and start saving for the anticipated expense well in advance.
If you decided to not borrow money to pay for your next car, how much money do you go about saving for it. It’s actually no rocket science. It’s very basic math.
A simple formula to adopt for calculating the money you’d need in a sinking fund is as follows:
Total Fund = Total Expense / Number Of Months
e.g., If you had to save $8,000 in 24 months, you’d be required to save about $333 every month to meet the goal.
Some might say that they might as well pay the same money as a car payment rather than paying cash for purchasing a car. While I do agree that it’s possible to do it, I would like to challenge your thinking by asking you to take a harder look at the expense. Do you really think it’s worth it to go into debt to buy a car? Can you not save for it and buy it in cash?
This simple trick makes you internalize the actual cost of them, and your mind will now process the payment differently. It forces you to question if you really need to spend (8K or whatever amount) that much on the purchase. If you did feel it was worth it, your mind will then be forced to think about what you can do to come up with the cash.
Another side effect of having a sinking fund is that it allows you to adjust your timeline of purchase in case the original plan doesn’t look feasible anymore. So if $333/month seems too big to afford, you can push the deadline to reach the desired amount or bring down the final price of the purchase or find new ways to make more money to meet the expense. It forces you to be creative or rethink the purchase.Having a sinking fund lets you tackle many expenses at the same time. You can adjust your budget to reflect accommodate the monthly savings goal as part of your monthly expenses. Click To Tweet
This is often one of the main reasons why people are caught by surprise when they hit the holiday season or get talked into an unplanned purchase. Having a sinking fund makes you intentional about a big purchase and not let you make decisions on the whim.
When Should You Use A Sinking Fund
Like I mentioned earlier, a sinking fund allows you to tackle a significant expense by saving for it on a regular basis. This makes saving for the purchase very affordable and not a herculean task. Let’s take a look at some of the most common scenarios where a sinking fund makes sense.
- Home Repairs And Remodeling
- Cover A Planned Medical Expense
- Plan for Major Purchase
- Property Taxes
- Insurance Premiums
- Membership Renewals
- House Downpayment
- Holiday Shopping
- Purchase Gifts For Friends & Family
- Car Maintenance
Where Should You Save Your Sinking Fund
Sinking funds are typically required in the short term. These are things you need to pay for or buy within a few months or at most in a year or two. So anything that falls more than the 3-5 year mark, you’ve got to reconsider if it’s truly a sinking fund or not.
Given the time horizon and the importance to preserve the capital, it’s never a good idea to invest your sinking fund in the stock market. My rule of thumb around investing any money in the stock market is: If you need the money before 5 years, I won’t risk investing it into the stock market.
Given this, you should be ok with your sinking fund being as accessible as possible yet still manage to scrape whatever interest it can earn during this time. The following types of accounts are ideal for having your sinking funds.
- High Yield Online Savings Account
Some of the best online savings accounts today offer an APY of 2.5% – 2.75%. I feel earning this on your sinking fund is a great way to stretch your dollar without subjecting your capital to unnecessary risk.
- Money Market Account
This is your next best option since it combines the high-interest rates offer by an online savings account and the flexibility of owning a debit card to withdraw it. If you are looking for a bank account that gives you the best of both worlds, a money market account will serve you well. Typically some money market accounts have a limit on the numbers of times you can withdraw money from it per month. So be mindful of this before choosing this option.
- Hybrid Checking Account
This would be my last resort, and I wouldn’t go with this option since the interest rates are not that great, but it usually offers the highest flexibility in terms of withdrawal options. You could use online banking or an ATM or even write cheques with it. However, there aren’t many banks that offer this type of account. So if you do come across one and it meets your criteria, give it a shot.
I personally recommend you to go check out maginfymoney.com to get the best possible rates on all the different types of account i’ve listed above.
Have you used sinking funds before? I would love to hear your thoughts on how you went about approaching it.