Planning for a big purchase? Businesses often use “sinking funds” to pay off debts and plan ahead for huge costs. What is a sinking fund? It may sound like a bad thing, but it’s far from it. A sinking fund is a savings fund used to prepare for future purchases. Instead of paying for the item after you purchase–while it sits on your credit card and accrues interest–you simply set aside a decided amount of money regularly to contribute towards getting that planned purchase. This can be anything from a new tv to a house.
Sinking Funds vs. Traditional Savings Account vs. Emergency Fund
You don’t want to confuse a sinking fund with a traditional savings account or emergency fund; they serve different purposes.
Sinking funds: save for upcoming (expected) expenses
Traditional savings account: save for long-term goals, like retirement
Emergency fund: save for unexpected expenses, such as healthcare or car repairs
Types of Sinking Funds
Sinking funds can be used for several purposes; however, the most frequent are typically expected health, auto, home, experiences, and vacation-related costs. Here are some examples of things you might want to start a sinking fund for:
- Home upgrades/furniture and maintenance
- Planned medical expenses (non-emergency surgeries, childbirth, etc.)
- Child care
Benefits of Sinking Funds for Personal Use
The benefits of using a sinking fund for personal use are broad. By using a sinking fund, you’re avoiding a high-interest credit card or loan that is unnecessary when you can reasonably plan for these upcoming expenses.
For example, if you financed a new $1,000 couch with 29% APR, you’d end up paying about $263 extra in fees and interest. If you spent a year saving up $1,000 on your own instead and then bought that couch outright, you’d have to wait longer for that new couch, but you’d save that $263.
How Many Sinking Funds Should You Have?
Choosing how many sinking funds you should have will differ based on the person. It’s best to not plan for more than five expenses at a time if you can prevent it. Anything more than that will be difficult to manage and will eat away at your checking account!
Keeping a wish list is helpful to prioritize which items you would like to save for and on what timeline. It also serves as a way to not overload your number of current sinking funds. This will help you focus your savings on the plan purchase the soonest and/or most urgently.
How to Create a Sinking Fund
A sinking fund acts like a savings fund. It is funded with the extra income you predetermine to set aside to meet your purchase timeline.
To figure out how much money you will need to set aside, you will need to determine how far out the purchase is, how much the purchase is for, and how quickly you can start to set savings aside, and at what frequency (weekly, semi-monthly, monthly, etc.) you intend to do so.
For example, if you want to buy a $500 TV in approximately five months, you may decide to set aside $100 per month for five months then pick up your new TV already “paid off” without having to owe any interest.
The best way to set this up to prevent you from reaching into your funds for other purposes is to have a separate savings account for each sinking fund. However, be wary of where you’re setting these up. Some savings accounts are NOT free to set up or require a minimum balance. You can also use a budgeting tool like Mint to set up separate trackers for each purchase you are saving for.
When in doubt, Rain app users can live chat with financial wellness coaches to learn more about saving and budgeting for both planned and unplanned expenses.
About the Author
Tom is a wealth management researcher and has years of experience working in the financial services industry. He is passionate about helping people better understand their personal finances. Outside of work, Tom loves to be outdoors and particularly near a beach somewhere.