From all-inclusive vacations and purchasing a new car to home renovations like that kitchen upgrade you’ve been dreaming of and even getting ready for family celebrations, there are so many different things that every single one of us plans for which usually comes with a price tag.
But how exactly can you and should you be saving for these types of planned purchases?
The answer: sinking funds.
Having a sinking fund, or even multiple sinking funds can play an extremely important role in your financial life. By using a sinking fund, you’re essentially making it easier for yourself to prepare for future expenses by tucking away a small amount of money on a recurring basis until you’ve saved enough to either cover the full cost or hit some relative “saving goal”.
Sinking funds go above helping you save for small and large planned expenses, they can also help you improve the way you manage your overall finances by keeping you motivated, focused, and picking up new money habits along the way.
Ready to learn more about sinking funds and how you can leverage them? Don’t stop reading here.. Keep going 🙂
“What the heck is a sinking fund and how do I start one?”
By now, I’m sure you can tell that we’re big fans of sinking funds around here. There’s a good chance that you also likely have a general idea that sinking funds come with benefits. But… you’re still not sold, right? No sweat, that’s what we’re here for.
Keeping it as simple as we possibly can, a sinking fund is a dedicated, usually separate, type of savings account or “fund” (hence the name!), that allows you to put money aside for purchases and expenses that you’re planning for in the future. future planned purchases. Your sinking fund(s) usually align with what your priority savings goals are—saving for a trip to Mexico? Create a sinking fund for that. Saving for your wedding dress? Create a sinking fund for that. Saving for a… you get the point!
Sinking funds “work” in a similar way to other types of saving funds or even investment accounts that you’re familiar with; usually by saving a small amount of money on a recurring basis, which usually ends up being monthly, for a specific amount of time until you’ve reached your goal. By the end of this ‘period of time,’ you should, fingers crossed, have enough saved to either cover the full cost of the expense or at least enough to cover the amount you were hoping for.
Here’s how to calculate how much you should be saving
The question then remains, “how much money do I need to be saving monthly?”. Just like everything else, it depends.
In this case, it depends on two numbers.
- The total amount you plan on spending (or thus needing to save); and
- The amount of time you have until you are considering making the purchase.
Once you have those two numbers figured out, your math becomes really simple—take the total amount you plan on spending and divide it by the number of months, weeks, or even days you have left until you plan on making the purchase.
The number you’re leftover is the amount you’ll need to save on a daily, weekly, or monthly basis to reach your goal.
Mexico here we come…in 12 months
Let’s have some fun and use an example of saving for a trip to Mexico to illustrate some numbers. For the purpose of this example, let’s assume that you’re planning on booking an all-inclusive, $3,000 trip to Cancun, Mexico in exactly twelve months from now.
Using that simple formula above, we would divide the total amount of the trip ($3,000) by the number of months you have left until you need to make the payment (12 months), which gives us a number of $250.
Based on those numbers and that timeframe, it looks like you’d need to save $250 every month over the next 12 months to reach your savings goal of paying for your $3,000 trip to Mexico.
“Why do I need a sinking fund?”
There are several reasons why you need a sinking fund or why you would at least consider using one… But the number one reason is this; because life happens.
It’s inevitable that there will be purchases you either want to make or need to make in the near future. Without a sinking fund, you might just find yourself being “forced” to pay for those expenses by resorting to other sources such as pulling money from your emergency fund, dipping into your retirement savings, or even busting out your nearly-maxed-out credit card. Resorting to those options doesn’t do you any good, in fact, it means you’re jeopardizing your financial situation and compromising your future financial health.
That’s what makes sinking funds so amazing— they allow you to plan for large (or even small), expected purchases without compromising your finances while still remaining on track in other areas of your financial life, such as your retirement. Taking advantage of using sinking funds can help you stay out of debt while avoiding feeling even the slightest pinch on your monthly budget.
By using a sinking fund you can:
- Save for large upfront costs without feeling anxious or intimidated.
- Plan and save for those dream items.
- Importantly, save and spend your money without regret.
“Are there different types of sinking funds?”
There really are no rules when it comes to what your sinking fund(s) should or shouldn’t be used for, that’s entirely up to you and your goals. However, every sinking fund can be placed into one of two categories:
- Large planned purchases. Most sinking funds will fall into this category as this is the most common use of a sinking fund. Saving for that trip to Mexico we talked about above, your dream wedding, and a down payment on a new house are all examples of large planned purchases.
- Small planned purchases. Next, are the smaller planned purchases that a sinking fund can benefit. This would include things such as family birthday celebrations, home decor, camps and weekend retreats, or even saving for back-to-school clothing for the kids.
When you break out your funds into these categories, it makes saving for and planning for just about everything else so much easier to understand what you’re working towards.
“What’s the difference between my sinking fund and my emergency fund?”
We get this question asked ALL the time. So, are there any differences between your emergency fund and a sinking fund?
While there are similarities, there is also a very distinct difference.
Your emergency fund is a reserve of money used for unplanned and unexpected expenses that come your way–in other words, for “emergency” occurrences. This can include things like the sudden loss of unemployment and income, your furnace or air conditioning unit breaking down, or getting a steep medical bill that you didn’t expect.
Sinking funds on the other hand, are explicitly designed to help you pay for those planned, expected expenses you know you’ll either need to make or want to make in the future. Examples include saving for family birthdays and celebrations, saving for an engagement ring or wedding dress, or even saving for an annual family trip or vacation.
So, the important takeaway is this: your sinking fund is for the known, while your emergency fund is for the unknown.
“Where should I create and keep my sinking fund?”
NOW this is what really excites us.. for obvious, slightly biased reasons 🙂
With that being said, best practice will tell you that you should be keeping your sinking funds in liquid savings accounts where you are earning a small amount of interest while knowing that you can access and pull your money at any time.
It’s totally up to you how you structure your savings and your sinking funds. You can use one account for everything you’re saving for as long as you track how much money you’re assigning to each planned purchase or savings goal. While that works, it can become a little messy pooling your money together.
We recommend creating separate sinking funds (savings accounts) for each different item or savings goal that you plan on saving for. So, if you’re saving for that trip to Mexico we talked about above, a small down payment on a car, and a nice anniversary gift for your partner, then we’d recommend using three distinct, separate accounts so that you can allocate different amounts to each account while being able to track your progress separately.
Moving forward with your sinking funds
Here at FRUGL, we make it easy to create new savings accounts based on your savings goals, categorize them, create your total saving goal amount, along with the time you plan on reaching those goals. Once your accounts are set up and making automated contributions, you’ll be able to easily track your progress to see just how much you have left to save for each goal.