What Are Sinking Funds and How Should You Use Them?

What Are Sinking Funds and How Should You Use Them?

Sinking funds are an often-overlooked personal finance concept. However, they can really help you stay on track and avoid budget overruns. The basic premise is simple. Every month you “sink” a little bit of extra money into a specific budgeting category. It could be transportation, planned purchases, personal entertainment, or vacations/holidays. Then, if a rare opportunity or unexpected expense comes along, you’ll already have extra money on hand to meet it.

Why Sinking Funds Are Handy

As a simple example, consider your personal entertainment budget category. Imagine you set aside $300 per month for nights out, movies, shows, sporting events, concerts, and the like. What happens if you’ve spent most of your monthly allowance when your all-time favorite band announces a surprise reunion show in a nearby city? You’d love to see it! But between tickets, travel, meals, and a hotel, you’ll blow your budget out of the water.

 

Well, you could dip into next month’s $300 allowance. But then you’d eat up your future entertainment budget ahead of schedule. That would leave you spending most of the following month (or longer) on your couch, instead of going out and having fun doing the things you love. Most people won’t stick to it. They’ll just carry on as normal, floating the extra expenses with credit cards, accruing interest charges, and derailing their financial plans.

 

A sinking fund solves this problem. Using nice easy round numbers, suppose you commit an extra 10% to a personal entertainment sinking fund. That means you’ll set aside $330 every month, but only spend $300. Over the course of a year, you’ll have an extra $360 available for special occasions. You know, like surprise concerts featuring your favorite band. Or a playoff game when your favorite team makes a Cinderella run. You can get yourself tickets, meals, and a place to stay without a single worry about how you’re going to pay for it. The money is already there!

 

Sinking Funds vs. Contingency Funds

Sinking funds are related to contingency funds, but these two budgeting tools are not the same. They have comparable functions, though. Both provide forms of insurance in the event of unexpected expenses. However, they differ in that sinking funds are intended to cover particular budget categories, while contingency funds are general allowances that you set aside in case of a major, prolonged financial emergency.

 

Breaking It Down Further

• Contingency funds usually contain three to six months’ worth of living expenses. They are designed to cover your housing, bills, food, and other essentials in the event of a job loss or other unforeseen emergency that impacts your ability to earn income.
• Sinking funds simply allot a little extra money toward specific aspects of your budget to prevent overruns. They help keep your overall financial plan on track.

It might not seem like a big deal to float the odd extra, unexpected expense out-of-pocket. However, such situations tend to happen over the course of a year more frequently than you might think. Add them all up and you could be looking at thousands of dollars in expenditures that you never accounted for in your initial budget. That could wipe out your entire year’s savings, leaving you spinning your wheels and never really making progress toward your long-term financial goals.

 

What Budget Categories Benefit the Most From Sinking funds?

Personal finance experts generally recommend creating sinking funds for budgeting categories that tend to come with the most “surprises.” Common examples include these areas.

 

• Technology: There’s no telling when you might lose your smartphone or try to turn on your laptop only to find it won’t boot up. Having extra money in your technology budget will help you repair or replace these items without worry. Moreover, technology advances quickly. There’s always a push to replace aging devices with newer, faster, better products.
• Vacations, holidays, and travel: When was the last time you took a trip without encountering unexpected expenses you hadn’t planned on? It doesn’t happen very often. Beef up your vacation and travel fund with some extra cash to cover these shortfalls.
• Transportation: This is particularly important if you own a vehicle, especially if it’s an older model. Repair and maintenance costs can wreak havoc on your budget, but a transportation sinking fund will really ease the sting.
• Planned purchases: You will usually know in advance if you need to finance a major purchase like a new car, new TV, or new furniture. However, it’s not always possible to accurately predict exactly how much these things will cost. Adding a little extra to a sinking fund for planned purchases will give you some helpful breathing room.
• Household expenses: If you own your own home, it’s a wise idea to pad your budget to cover things like appliance breakdowns, furnace or roof repairs, and broken windows.

You can also create sinking funds for things like “forgotten expenses.” These are the little things people often overlook when they’re budgeting. Costs like periodical subscriptions, software licenses, pizza delivery, birthdays, and hosting social events. Accounting for them will improve your budgeting accuracy and make it easier to meet your savings objectives.

 

Savings Strategies for Sinking Funds

There are two main ways to set aside money for your sinking funds. One is to create a general pool of cash for all your sinking funds. The other is to set aside an additional percentage of your usual budget for particular categories. The first method is easier, but the second is more precise.

 

Here’s an example of how the first method works:

 

• Determine how much money you are able to commit to overall savings each month.
• Set half (or a third, or a quarter) of that money aside, and account for it in a generalized sinking fund.
• Use your sinking fund to finance unexpected expenses and general budgeting overruns, subtracting these expenses from the fund as they pop up.
• If you opt for this approach, remember one simple point. The more you are able to set aside for your sinking fund, the more flexibility you will have.

 

For method two, formulate a personalized strategy that draws on the following principles.

 

• Create reasonable, practical monthly budget allowances for all your spending categories.
• Consider which categories tend to carry the most “surprise expenses.”
• Create category-specific sinking funds for each of those categories.
• Add an extra percentage to your budget (say 5% or 10%) and account for it your specially designated sinking fund.
• Track your regular spending in the normal category budget.
• Track your unexpected and emergency spending in the sinking fund budget.

Tools for Tracking and Managing Sinking Funds

People use two main types of tools to track their sinking funds. Spreadsheets and personal finance software. Spreadsheets give you the flexibility to create custom categories as you see fit. However, they they require more maintenance and cross-checking. After all, it’s up to you to manually track everything. Personal finance software often uses an envelope-based system to track your categorized budget allotments. It can be a much more intuitive way to create, track, and maintain sinking funds for specific types of expenses.