What is a sinking fund and do you need one?

What is a sinking fund?

At its simplest, a sinking fund is a place where you keep money for a specific goal. It's a place to “sink” your money for a purpose. The idea is that you can save for individual goals with individual accounts, earmarking the funds and building toward your objectives a little bit at a time.

A sinking fund allows you to spend big on the things you want — guilt-free.

Companies also use sinking funds to help pay off debt, such as bonds. When the bonds mature, the company can pay it off without having to scrounge for the lump sum. Instead, they've gradually worked toward paying off the debt by setting aside money during specific times.

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How does a sinking fund work?

A sinking fund is designed to help you save for big things in a way that allows you to splurge guilt-free. It's less about aiming for one end number for your funds and more about building up a fund that you can access when you want.

For example, I have a couple of sinking funds for different purposes. I set aside the same amount of money each month in an account earmarked for travel. And I have a different fund for electronics. I put the same amount of money aside, and later when I'm ready to spend, I see what's in the sinking fund.

When my laptop finally gave out on me, I checked my electronics sinking fund to see how much was available. It helped me decide how much to spend on a new laptop.

With the travel fund, when I want to go on a trip, I can just dip into the money, whether I'm paying for a three-day weekend getaway or a river cruise.

Why do I need a sinking fund?

It may seem like sinking funds are a little unnecessary. After all, they are very similar to savings accounts. With a savings account you have a large amount of money and then just use it for whatever you want.

Some of the reasons that sinking funds make sense include:

• Allows you to earmark money for anything. You can see how much you have for different purposes, and it's easier to spend guilt-free when you're ready.
• Save for multiple goals at once. One of the advantages of sinking funds is that they allow you to work toward more than one goal. This gives you progress milestones and you can see where you are, making it a little more concrete.
• Your fund keeps growing. Another good reason to use sinking funds is that your money keeps growing for ongoing goals and expenses. Plus, if you feel like one fund is getting too big, you can shift some of the monthly contributions to a goal that needs more.

Basically, your sinking funds help you keep things separate. And they help you better clarify your goals when saving up for more than one thing.

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How do I set up sinking funds?

Setting up your sinking funds is fairly straightforward. Basically, you just set up an account for each priority you have. You can do this by setting up separate savings accounts. Or you can look for a bank that offers sub-accounts.

Some institutions let you set up different goals and divert money based on your priorities. This makes it easier to monitor your progress and see how much you have for each goal.

How many sinking funds should I create?

You can set up a sinking fund for each major goal you have. However, you don't want to dilute your sinking funds too far. Think about some of the larger expenditures you run into and then figure out how you can make small contributions toward them each month to make them more manageable.

Depending on your situation, you might consider limiting yourself to between six and eight sinking funds, although you may be fine with fewer.

And depending on your institution, you may end up being limited on the number of sub-accounts you have or goals you can save for. Pay attention to those situations as you consider how many funds to set up.

Where should I keep my sinking fund?

Many people are most comfortable keeping a sinking fund in a high-yield savings or money market account. That allows them to maintain access to the funds while receiving a higher yield. Plus, the money is insured by the FDIC. Here are some recommended services:

However, depending on your risk tolerance, you might keep some of your sinking funds in a taxable investment account. You could use bonds, dividend stocks and exchange-traded funds (ETFs) to grow your sinking funds a little faster. However, you also run the risk of losing your principal, as well as the potential tax consequences of selling if you have a gain.

How Is a sinking fund different from a savings account?

When you have regular savings account that you plan to use for a specific goal, you usually have a target amount of money in mind. Perhaps you want to save up $1,000 for holiday gift-giving. You know you need to set aside $100 for 10 months in order to reach that goal. You have a target amount and an end date.

A sinking fund is similar in that you keep it in a savings account and you have a purpose for the money. However, you don't have an end date. Instead, you decide how much money you want to put toward general goals, and when it's time to spend, you have money available to you.

Sinking fund example

Let's say that you know you can set aside $500 each month. And you have a few different goals. Instead of putting $500 into general savings account for a total of $6,000 over a year, you instead divide that money based on your priorities. Perhaps you have five sinking funds:

• $150: Travel
• $150: Car
• $75: Home repairs
• $75: Medical costs
• $50: Electronics

You still have $6,000 in your accounts each year, but the money is earmarked for different purposes:

• $1,800: Travel
• $1,800: Car
• $900: Home repairs
• $900: Medical costs
• $600: Electronics

If you need something, you can tap into the fund to pay for it. You don't have to use all the money in the fund, and you can keep contributing each month.

Perhaps at the end of the year, you decide you want to go on a trip that costs $800. You spend the $800, leaving $1,000. And you keep adding money to the fund. Next time you want to travel, you have a larger amount in the sinking fund and can take a more expensive vacation.

It's also possible to adjust how much you contribute to your sinking funds depending on your needs and how often you tap into them.

Use a sinking fund for ongoing costs

Sinking funds aren't for everyone. However, if you're looking for a way to save for ongoing costs and you want a manageable way to prioritize some of your objectives, a sinking fund strategy can be a good way to move forward. It requires a bit of patience to set up. But with a bit of discipline, a sinking fund can make your personal finances easier to manage.