Budgets are the key to getting out of debt, but how do you allocate for expenses in the future in your budget? Well, you can start acknowledging these expenses now with sinking funds.
What are Sinking Funds?
“Sinking funds” are a strategy to plan for future expenses. You may already be aware of the strategy – even if you’ve never heard of the term.
A sinking fund is a small amount of money set aside regularly in a savings account (sometimes multiple savings accounts) for a larger known expense that you’ll need to pay in the future. An example of one of these expenses might be buying a car, a vacation, or even Christmas gifts.
Essentially, you are setting aside money a little at a time to “sink the debt” you know you’ll have in the future instead of letting it catch you by surprise.
Why Do You Need Sinking Funds?
Imagine the power of having the money saved up for Christmas before buying presents? Or saving up for a weekend vacation and knowing you can afford it before you leave? Sinking funds allow you to tailor your budget to your hopes and dreams without needing to dig into your emergency fund, savings, or go into further debt.
Sinking funds are just one part of your zero-based budget (if you’re not familiar with the concept of zero-based budgeting, please check out zero-based budgeting for beginners), they act as a safety net for expenses on the horizon, such as:
- Buying a car
- Home renovations
- Tuition and school supplies
- Wedding expenses
- Holiday Presents
- Buying a new laptop/tablet
- Yearly & Quarterly Taxes
- Car registration renewal fees, inspections, and other non-monthly expenses that we can expect but often may forget to include in our budgets.
Steps to Start a Sinking Fund
Creating a sinking fund is easy. It’s just three easy steps, and once you analyze your budget, you may realize you need more than one fund for different size expenses.
1. Define the Expense
Write down a list of all the things you could create a sinking fund for and then prioritize them in order of importance.
If you aren’t sure of the exact amount needed for each expense, an estimate will suffice but try and get as close as possible. For example if you know you’ll need new tires for your car this year, get a price quote now.
For this example, let’s say you need to save $200 for September back to school supplies, and we’ll need it in 10 months.
2. How Much and How Often?
Decide how much money you can set aside and how frequently you can afford to do so. In our example mentioned above of $200 for school supplies, that’s $20/month for ten months to reach that goal.
The earlier you start thinking of your goals the less you will need to put aside each week or month.
3. Time to Put it in Your Budget!
Once you’ve defined your expense and determined how much you’ll need to save each month, it’s time to add it to your budget.
You’ll add the monthly amount to your budget as an expense under ‘sinking fund’ and commit to it.
Step 3 is important. It’s easy to skip a month or dip into the fund for something else, but you must put the money in and then ignore it for the sinking fund to work.
The money set aside for the sinking fund must be as important as any other expense in your budget. Treat it as you would any other bill!
If you follow Dave Ramsey’s 7 Baby Steps, sinking funds can help prevent further debt in Baby Step 2. Take care to reassess each item you’re saving up for regularly, as the sinking fund may become multiple lines in your budget if you’re planning multiple expenses simultaneously.
WHERE TO PUT SINKING FUNDS
How you set aside the money for your sinking fund is up to you, but there are a few options:
In the Bank in a Separate Account
Some banks offer automatic withdrawals that you can set-up in advance, so a predetermined amount of money comes out on a set date and you then put it into a savings account. I would HIGHLY recommend using a separate savings account from your emergency fund for this.
The other option is moving the money manually into a saving account each week or month as if you were paying a bill.
Most banks will allow you to have multiple savings account with no extra fees so check with yours and see how to best set this up.
Take it Out in Cash
The other option is withdrawing an amount in cash each time you receive a paycheck and setting it aside. Many people are using the cash envelope system for this purpose.
While this option offers the greatest amount of control, it must be done regularly and offers the greatest degree of opportunity for a payment to be forgotten so be sure you are regularly withdrawing the cash and putting it into a cash envelope.
You’ll also need a safe place to store the cash especially if it’s a larger amount but this method works well for those who are already using the cash envelope method.
Sinking funds not only have to be defined but they have to be realistic. Yes, we might want to save $1000 for Christmas and $5000 for a vacation but after going through the steps you may find you don’t have enough money in the budget for all your sinking funds. If so, go back and prioritize again.
Maybe you need to lower your goal amount and take a $2000 vacation or cut your Christmas budget in half. Once you’ve successfully saved for a few expenses using sinking funds you’ll be better able to plan for them in the future because you’ll know what works and what doesn’t.
Sinking Funds Versus…
When exploring what sinking funds are and why you need them, it might be tempting to use savings or your emergency fund to pay for expenses instead. Sinking funds are your budget’s superpower. Here’s how they stack up to your other savings accounts.
Your savings should be quietly growing in the background. As your savings grow, they will start to gather interest and become more profitable. You don’t want to remove money and delay its work. Savings also need to be added to regularly, but they need much more time to grow.
A sinking fund won’t increase your net worth, but it allows you to do the things you want to do in life and help you with bigger ticket purchases without the guilt. You tailor a sinking fund for a goal, with you having the ability to spend that money once you’ve achieved your goal.
Sinking funds are not for emergencies. In fact, sinking funds are to avoid suddenly having to pay a large sum out of pocket for an expense that you have planned or could have easily predicted. Decisions like vacations are usually planned months in advance, and you can set a small amount aside every month to pay for it.
Annual expenses like tuition are predictable; you must pay them each year. These benefit from sinking funds and allow a plan to be easily calculated around them.
A broken window might be an expense for your emergency fund. However, you would choose to create a sinking fund for painting your home since that is a planned expense.
Also an emergency fund should take priority over say a vacation sinking fund. I recommend having at least a starter emergency fund of $1000 before any vacation sinking fund. After that I actually recommend starting a sinking fund to fully fund an emergency fund with 3 to 6 months worth of expenses.
Sinking funds are a key part of any budget. They act as your budget’s superpower, allowing you to address expenses before they arrive and allow you to save up for major purchases while paying your regular expenses.
It takes time for savings to start to work for you, and you should save your emergency fund for emergencies. With sinking funds, you can make purchases without the guilt because you’ve saved your hard-earned money and strategized where every dollar will go.
Now, when someone asks what sinking funds are, you will already know.
Now it’s time to do it! Sit down and dream big – what would you like to save up for, and what expenses will be coming up that you can get ahead of?
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