What is a Sinking Fund? The Key to Smart Budgeting

Most people spend their entire year looking forward to the Christmas season! Getting together with family, eating great food, and celebrating the birth of Christ.

Oh and one more thing!

Presents.

That’s when the anxiety starts to hit. You start to ask yourself, “How am I going to pay for all these gifts?”

You realize that you should have planned ahead, setting aside a little bit of money each month so that it wouldn’t be such a big hit, but somehow you forgot again. So you do what you always do…

Reach for the credit card. Rack up another round of debt at a skyhigh interest rate and pray that you’ll be able to pay it off quickly when you start budgeting in the new year.

Christmas comes every year. It’s never a surprise, but somehow it always manages to surprise our budget. It’s always on the same day, yet we are never ready for it.

But Christmas isn’t the only thing that surprises us.

New tires. Birthday gifts. Anniversary plans. Vet bills. New car.

These things happen at a somewhat regular pace, yet we never have the money ready for them.

Why do we let these things continue to take us by surprise?

Today I want to share with you one of our best tactics to sticking to our budget. This one tip helps us avoid major spending hits and allows us to avoid racking up credit card debt.

Now! For my #1 budget tip as you head into 2018…

The Sinking Fund: A Lazy Man’s Tool for Budgeting Success

With a sinking fund, you set aside a small amount of money each month for a certain amount of time before you make your purchase.

You set up your bank account to automatically transfer a set amount each month. Once you reach the amount you need, then you can put the transfers on pause until you use the money in the fund.

Once used, you can replenish the amount as needed.

The strategy is simple. Take the amount you expect to pay and divide it by the number of months you have until you will need it.

Let’s use Christmas as an example.

Every year we know we are going to spend roughly $600 on gifts for our family. Rather than wait until December to figure out how we are going to pay for these gifts, we set aside a small amount each month.

$600 / 12 = $50

This allows us to get through the Holiday season without feeling like we are going to go into a budget crisis. Christmas is an easy one because it happens the same time every single year. But sinking funds can also be used for one-time expenses.

At its core, setting up a sinking fund is proactive planning. We plan ahead for as many major expenses as we can so that our budget is more insulated from big ticket spending.

Differences between a Sinking fund and Emergency Fund

All this talk about setting aside money each month for major expenses might sound familiar. It’s easy to get emergency funds and sinking funds confused, but there is one simple difference that should help you out.

Emergency funds are for unexpected events that you don’t have control over. They are used when you get in a car accident, when your AC goes out, or to cover your expenses in case of an unexpected job loss.

Emergency funds are used to protect you from the things you can’t predict.

On the other hand, sinking funds are set up for expected expenses. These are budget items you can reasonably plan for and predict. They happen every year, or you expect they may happen soon.

Here are 7 Examples of what Sinking Funds used for

1. Vacation

Let’s say you know you have a backpacking trip coming up next year or you have a destination wedding a few months down the road. Take the amount you expect the trip to cost and divide it by how many months you have left until you leave.

Set that amount aside each month into your sinking fund and when the time comes, you can pay for it without needing to worry about paying the bills.

2. Car Insurance

One great way to save money on car insurance is by prepaying it every 6 months. So instead of paying $150 every month for 6 months at $900 total,  you might be able to pay $850 up front, saving you $50.

The trick is actually having the money ready up front and then saving for the next bill 6 months later. A sinking fund can help you do exactly this.

Even better, you can automate it to transfer automatically so that you don’t have to remember each month.

3. Car Repair or Tires

I’ll admit that this one is a little trickier to predict, but let’s say you look down at your tires one day and notice that the tread is starting to run low. Most people would shrug it off and try to ignore it for the next few months.

When the time comes, they put the tires on their credit card and rack up another $1,200 in high interest debt.

Not you. You’re better than that.

The same day you notice the tread starting to wear out, you set up a sinking fund specifically for your tires. When the time comes to buy new ones, you can pay for them on the spot.

4. Contacts

My wife uses dailies for her contacts. I used to think this wasn’t a big deal until our first year of marriage when I choked on my lunch when I saw a $400 bill for contacts. Being the inexperienced budgeter I was, a year later I had the same shock when I saw the bill again.

Now, we transfer $35 each month and when the time comes the money is sitting there ready to be spent.

5. Any annual memberships

If you have any memberships that are paid annually then a sinking fund is a great way to spread the cost out on a per month basis. We have a Costco membership, so we deduct $5 each month.

6. Home Repair, Appliances, or Furniture

This is another one that could fall into the emergency fund category depending on how you look at it. But I hope that all of you smart budgeters out there will plan ahead as best as you can for possible house expenses.

For example, let’s say you just bought your first home. It’s an older house, so you know that you will need to replace the AC unit in the next year or two.

The smart budgeter will start saving immediately for that upcoming expense in their sinking fund.

7. New Car

If you are driving an older car with some serious mileage on it, then you know that you are eventually going to have to replace it.

If your 2005 Camry with 217,000 miles dies on you next week, that is something you should have been planning ahead for.

Sure, you can’t predict when exactly you’ll need the money to buy a car. But the more you plan ahead, the less of a curveball this will throw at you.

How to Structure a Sinking Fund into your Budget

Most people love the idea of setting up a sinking fund. It reduces financial stress, helps you budget for future purchases, and it gives you a plan that you can stick to.

But how do you actually structure a sinking fund into your budget?

Easy.

Someday I’ll write a full “How to Make a Budget” guide, but here’s a start.

Income: How much you bring home each month

Fixed Expenses: These don’t change month to month. There may be wiggle room for you to negotiate these rates and lower them, but until you do, they are static.

• Rent
• Wifi
• Debt Payments
• Gym Membership
• Phone Bill
• Insurance

Variable Expenses: These change month to month. If you put the effort in, you can probably reduce some of these!

• Utilities
• Food
• Travel
• Eating out
• Gas
• Entertainment
• Etc

The problem for most people when they budget is that they stop after outlining their monthly expenses! And then every few months they get whacked with a major bill that they should have been expecting.

The best thing you can do for your finances is to automate as much as possible. When you get slammed by expenses that could have been planned for, you have to adjust your savings plan for that month.

Christmas comes at the same time every year! Why not start budgeting for it this January?

So here’s what you do.

Set up a third expenses category and title it, “Sinking Funds”.

Underneath, list out each of the major expenses you know you have coming up. Use the list above if you need some ideas!

Next, input the “Amount Needed” and “Months Remaining.

And now you know the monthly amount you need to be setting aside for each of these sinking funds.

Sinking Fund line-items

 

 

 

 

Finally, total them all up.

Now that you have a subtotal, your next step is to figure out where to keep your sinking fund.

Where to Keep your Sinking Fund

This is where it gets tricky.

But don’t worry, I’m going to hold your hand and walk you through the exact steps.

There are probably a dozen options for where to keep your money. I’ll walk through three options from easiest to most difficult to set up.

As you could probably expect, the most difficult scenario is also the most rewarding.

The key to all of these scenarios is to set up an automatic transfer each month, pulling money out of the account your money comes into from your employer, and into your sinking fund.

1. Savings account attached to your current bank

This is by far the easiest option you’ve got. Whoever you do your regular banking with, set-up an additional savings account.

Pros: Super easy to set-up, all your money stays in one place.

Cons: Lowest interest rate. Your return is next to zero and when you account for inflation, you’re losing money over time.

2. Online bank account

The only difference between this one and the first is the location. Most big banks like Wells Fargo, Chase, and Bank of America have interest rates that range from .01% to .09%.

An online bank like Ally offers 1.25% interest, roughly 100x as much as your traditional big banks.

3. Checking account with your insurance provider

This is another similar approach. Most auto insurance providers offer discounts if you are willing to set-up additional accounts. Depending on how much you have in your sinking fund, this is an easy way to get an effective 2-6% yield.

4. Bank account bonus hacking

This is the most complicated option, but yields the best results by a long shot.

Banks frequently offer cash bonuses to attract new clients. You have the chance to take advantage of the free money.

I’m not going to pretend to be an expert on this, so I’ll point you to the #1 resource you need to know about. The blogger, Doctor of Credit.

A Beginner’s Guide to Bank Account Bonuses

Best Bank Account Bonuses

I’m putting those two guides into practice this year and I’m looking forward to sharing my results.

Wrapping it up

I know the idea of setting up a sinking isn’t sexy or exciting. But this is one of the smartest budgeting decisions you can make. 

Do me a HUGE favor and comment below with any thoughts you have! I’d love to hear if you have any examples of what a sinking fund can be used for.