Do you have a large one-off purchase coming up in the future? Start setting aside money now! This is the basic principle behind sinking funds.
From a cursory glance sinking funds look a lot like amortisation, in that you're spreading out the cost of something over time – just you're spreading it out in advance of a purchase instead of after the fact.
What are Sinking Funds?
In short, sinking funds are where you dedicate a portion of income towards saving for a specific goal. For instance putting aside $200 a month for 5 months towards a $1,000 expense.
Sinking funds are great for anticipated purchases! It's much better to set aside free-flowing money rather than dipping into emergency funds, savings, or investments when the time comes around. That way if an emergency hits after you make the purchase, you still have your safety net.
Sinking funds are a staple in the toolbox of personal finances. That's because anticipated purchases should be a fairly normal occurrence in most lifestyles, and handling anticipated purchases is what sinking funds are all about.
There's two main ways of operating a sinking fund:
The first method is to open a separate savings account (or money market, or other handy cash account with your bank or credit union). The whole account is the fund for a specific expenses, e.g. your vacation fund. That way any money deposited into it is clearly earmarked for the sinking fund.
The second method is to commingle all the different sinking funds into one account, and to track how much each is funded via an external tool such as a spreadsheet.
Both options take about as much work, but have different ways that work needs to be done.
Why use sinking funds instead of savings accounts?
Sinking funds are specific to only one small goal, whereas savings are generally about financial independence and fuelling the largest purchases – like houses.
If your savings are earmarked for retirement or other long-term large goals, it can be hard to disentangle the funds you can spend in a savings account versus the funds that are crucial.
This runs the risk of over-spending and lifestyle inflation if you're not disciplined!
Making many medium-sized purchases can eat away at your largest goals. By using a sinking fund, you're containing the finances better. There's clear boundaries between goals and their progress.
Sinking funds also embody the principle of delayed gratification. Setting aside cash flow every pay period forces you to work and save for your goals, even if you're otherwise wealthy and could afford to buy something outright with your savings.
I believe it's important to keep a small challenge in place for your purchases, so that you don't get complacent. The things you have to wait for and work for are better appreciated when they arrive!
Sinking fund is a weird name
As with most confusing things in life, there's "historical reasons" why sinking funds are named such. Let's take a look at the industry-specific definition used by Investopedia:
A sinking fund is a fund containing money set aside or saved to pay off a debt or bond. [...] A sinking fund is established so the company can contribute to the fund in the years leading up to the bond's maturity.
A sinking fund helps companies that have floated debt in the form bonds gradually save money and avoid a large lump-sum payment at maturity.
Investopedia - Sinking Fund
In short, it's called a sinking fund because companies "float" debt, and the counterpart of floating is sinking.
Honestly I would love a better name for it. Cash flow stowage? Outlay fund? Capital expenditure fund? There has to be a better term!
Sadly, there's little hope of changing it. Sinking fund is too deeply rooted to change, and any replacements will likely be just as confusingly named.
What can you use a sinking fund for?
Any planned purchase that costs more than petty cash is a candidate for sinking funds. Here's a few ideas:
- Vacation or event fund
- Car repairs
- Home repairs
- Electronics purchases (TV, computer, laptop, etc.)
- Taxes (for the self-employed)
- Medical bills (HSAs are great for this)
- Tools and equipment
- Pet vet bills
- Building a shed or other projects
Sinking funds are a staple that belong in everyone's financial toolbox. You can use them to handle the typical but irregular purchases that inevitably crop up in life.
They're also handy for tricking yourself into feeling challenged, even long after you've achieved an abundance of wealth. This makes for better satisfaction with the purchases you do make, and combats lifestyle inflation.
All told they're handy to have around. You can bet that sinking funds will be right there alongside my war chest fund in my household's personal finances.