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What Are Sinking Funds and How Should You Use Them?

Published January 30, 2020

5 minute read

By Jim Greene

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

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.

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:

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.

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.

Sinking Piggy Bank Full of Money

Shutterstock

Jim Greene

Contributor

Jim Greene is a freelance writer based in the Toronto, Canada area. He has been writing professionally since 2001 and has an extensive professional background in consumer research, personal finance and economics.

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