Establishing a sinking fund means setting money aside now because you know you'll need it—or want it—later. You should be able to avoid most financial emergencies and save your emergency fund for something along the lines of illness or job loss. Your emergency fund should be reserved for something that comes at you out of the blue, something unexpected, while a sinking fund is for a planned expense, something expected.
How to Set Up a Sinking Fund
Dedicate an account to hold your sinking fund. It can be a run-of-the-mill savings account, nothing fancy, just a way to segregate the money. Naming it accordingly can help keep you motivated and avoid dipping into it for other things. Give it a tag like "Beth's New Kitchen" or "Bermuda or Bust!"
Note
If discipline isn't your strong suit, keep reminding yourself how happy you'll be when you've reached your savings goal. Imagine having or doing whatever it is you've been saving for whenever you're tempted to dip into the money for other things.
Now put a reasonable price tag on the expenditure. It can be tempting to go light, but then you might reach the finish line only to realize that you didn't save enough. Go too heavy and you might struggle and grow demoralized before you reach your goal. So research that kitchen or your Bermuda accommodations and set a realistic target.
Let's say your number is $6,000. Look at your budget. How much can you squeeze out a month? Something in the neighborhood of $500 will have you gourmet-cooking in your new kitchen in a year. It might sound like a long time, but look at it this way: You won't be going into debt to afford the remodel so you'll enjoy all that food a lot more without the added indigestion.
In some cases, you might already have a target date. Maybe that Bermuda trip is going to happen because your sister is having a destination wedding in 10 months. You'll have to up that $500 to $600 to make the nut, but you'll still be able to spare your credit cards a lot of heavy-duty lifting even if you can't manage that much. Saving even $200 a month means you won't have to charge as much.
Sinking Funds Can Be Precautionary
Sooner or later, you're probably going to have to tweak the exhaust system on your old car or call the plumber for a hopelessly clogged drain. Putting a little money aside each month now will make stressful events easier to manage. You're prepared.
Many people set aside money each month to cover these expenses without even realizing that they're technically sinking funds. And if you know you have a major repair coming up, you can determine how much you'll need to set aside to cover it in time.
Save for the Fun Stuff
Yes, we're back to Bermuda again. Set money aside to cover the cost if there's a dream vacation you're dying to go on, or even if you just want a chance to go to the beach this summer. Nothing ruins a vacation or a day off faster than knowing you really can't afford to be there. Your vacation shouldn't ruin your budget, and saving in advance is the best way to avoid that.
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Keep in mind that it might take you a few years to save up if you're on a tight budget, especially if you have grand plans.
Cover Medical Expenses
You might already have a sinking fund of sorts with your health savings account if you have a high deductible health insurance plan. You should be able to handle the rest of your medical expenses without too much trouble if you can save up enough to cover your annual deductible.
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You should also take into account any money that your employer will contribute to help cover your costs.
Consider how much you'll have to increase this type of sinking fund as you get married and have children. The amount should increase as your risks increase.
Plan for Major Purchases
Pay for major purchases with cash.You might start a sinking fund for the next car you want to purchase or save up for a down payment on a home. Establishing a sinking fund will help you to avoid going into debt and make it easier to purchase something you can truly afford. The more cash you have to put down, the less you'll have to finance.
The Bottom Line
Setting your sinking funds now will make it easier for you to reach your other savings goals and reduce financial stress. Track the money in a separate category in your budget. Treat it like a commitment and stay motivated as you watch the balance grow.
FAQs
You can use a sinking fund to save for irregular expenses, like insurance premiums or car repairs. Saving for large purchases over time. A sinking fund lets you spread out a large purchase over time by saving a little at a time. Avoiding using a credit card or taking out a loan.
How do you spend sinking funds? ›
You can use a sinking fund to save for irregular expenses, like insurance premiums or car repairs. Saving for large purchases over time. A sinking fund lets you spread out a large purchase over time by saving a little at a time. Avoiding using a credit card or taking out a loan.
How do you use a sinking fund explain your answer in detail? ›
Sinking funds are money you set aside each month for specific savings goals. They allow you to save for infrequent expenses and plan for large expenses over time. Having sinking funds can help prevent you from withdrawing money from your emergency fund or going into debt to pay for things.
What does a sinking fund include? ›
A sinking fund is a fund that includes funds set aside or borrowed to pay off a loan or debt. A business that issues debt will have to pay off the debt in the future, and the sinking fund helps ease the burden of a significant revenue outlay.
What does a sinking fund protect you from? ›
As a result, a sinking fund helps investors have some protection in the event of the company's bankruptcy or default. A sinking fund also helps a company allay concerns of default risk, and as a result, attract more investors for their bond issuance.
What are the sinking fund expense categories? ›
A sinking fund is money you set aside on a regular basis for specific things that only happen occasionally. Too often, people add to their savings without realizing what it's for or how much is needed. As a result, it's possible to be caught off-guard by expenses and find your budget falling short.
Which expense would be a reason to set up a sinking fund? ›
Plan for Annual Costs: If you have annual or semi-annual expenses like buying holiday gifts or insurance premiums for a house or car, a sinking fund may help you prepare for these costs ahead of time and reduce stress when those purchases roll around.
How do you treat a sinking fund? ›
Initially, a sinking fund is created and a fixed amount of money is allocated to it every set period. Over time, this pool of money will become larger, and then there are available funds to pay an old debt or replace the asset. Every year you allocate a certain amount of money to a sinking fund.
What are the rules for sinking funds? ›
Sinking funds are in 'trust' for the scheme and should not be returned to lessees upon assignment, or at any time. Interest earned on funds should be added to the funds unless the lease states otherwise. If funds are held in 'trust' then a tax will be charged on the interest earned.
What does a sink fund cover? ›
A sinking fund is money that has been charged over a period of time to pay for future works and repairs to communal areas.
A sinking fund is a reserve account that's set up to protect the value of a property. It is often used as an investment vehicle by investors who want to make sure their money will not be lost or devalued over time. Sinking funds can be used for various purposes, including: covering the costs of repairs and maintenance.
What is a reasonable sinking fund? ›
A sinking fund can also be set up by private landlords; simply by putting aside a certain amount of the rent received each month. When calculating the amount to be contributed, it is common for landlords to put aside anywhere in the region of five to ten percent of the rental income to allow to be used.
What are the disadvantages of a sinking fund? ›
Disadvantages of a Sinking Fund
Here are some more disadvantages: Opportunity Cost: The funds set aside in a sinking fund could earn a higher return if invested elsewhere. Over-funding: There's a risk of setting aside more money than necessary, which might affect the cash flow.
Where to put sinking funds? ›
You can choose to open a separate savings account for your sinking fund. Just make sure the account doesn't have a minimum balance to maintain (like a money market account). You don't want monthly fees to chip away at your savings.
How much should I put in a sinking fund? ›
To determine the amount to keep in a sinking fund, identify and list the anticipated expenses and their estimated costs. “Then, divide each expense by the number of months until it's due,” Rose said. “For example, if a $300 expense is six months away, allocate $50 per month to your sinking fund.
What is the 50 30 20 rule? ›
The 50-30-20 rule recommends putting 50% of your money toward needs, 30% toward wants, and 20% toward savings. The savings category also includes money you will need to realize your future goals.
What is a sinking fund mainly used for? ›
Basically, the sinking fund is created to make paying off a debt easier and to ensure that a default won't happen because there is a sufficient amount of money available to repay the debt.
How to prioritize sinking funds? ›
You pay toward your sinking fund in the order in which they are due. If you build financial flow charts, you can put them in that order to make sure you're on top of your bills as they come in.
How much sinking fund is enough? ›
If buying into a large strata scheme, you would expect a sinking fund to be hundreds of thousands of dollars. Equally, if you are buying into a block of six, the sinking fund could be reasonable with a balance of only $60,000, because it is a matter of proportion.
What is the accounting treatment for a sinking fund? ›
Accounting for a sinking fund
A sinking fund is classified as a non-current or long-term asset and is sometimes included in the list of long-term investments or other investments in a balance sheet. Companies requiring significant capital to purchase new plants and equipment issue long-term debts and bonds.
How do you calculate sinking fund? First, multiply the percentage interest by the principal amount. This will equate to the interest amount, which is then added to the principal amount. This total is the amount of money that needs to be in the sinking fund to meet the set financial obligation.
Why would you use a sinking fund? ›
In personal finance, a sinking fund is simply a savings account that you use to save for an expense that you know you will need to pay for in the future. The goal is to set aside enough money to cover this known expense so that you don't blow a hole through your budget when the bill eventually comes due.
What are the two ways a sinking fund can be handled? ›
Answer and Explanation: The two ways to set up a sinking fund are: The first thing is through trustees who invest the annual payments of the entities in government bonds, and the other way is to either retire the bond issues or selling or purchasing bonds, whichever is lower.
