What is a Sinking Fund?
In its simplest form, a sinking fund is simply a method of saving up to pay cash for expenses. It’s a simple formula of the expected purchase amount and the time until you want to make the purchase. Sinking funds can be used for major purchases, such as the purchase of a vehicle. Or they can be used for much smaller ones, such as saving for a new vacuum. No matter the purchase size, a sinking fund can help you pay cash for most everything! This is the method my husband and I use for all major purchases!
Why Use a Sinking Fund?
Look almost anywhere and you’ll find that the data shows that wealthy people don’t finance purchases. Some people think they pay cash because they are wealthy. In reality, they are wealthy BECAUSE they pay cash. They delay pleasure and plan their purchases, prioritizing their money for what really matters most to them. After all, it’s impossible to build wealth if you continuously go further into debt. Use sinking funds, don’t build up more debt, pay off debt you have, and then become wealthy. Wealth is less about income and more about outgo.
How to Set Up a Sinking Fund
This is where I wow you. Okay, it probably won’t wow you. Setting up a sinking fund is actually super simple. Let’s use an example. Let’s say you need to purchase a new refrigerator. The refrigerator you would like costs $1500. You plan to make the purchase in 8 months. Simply divide the purchase amount by the months you have to save. So, 1500 divided by 8 equals 187.5. To save up $1500 you’ll need to set aside $187.50 each month for 8 months. See, super simple. Have I wowed you yet?
The Key to Making Sinking Funds Work for You
Sinking funds simply won’t work for you if you don’t plan ahead. You need to look ahead, sometimes by years, to think of purchases you’d like to make. Some things are easy to think of. Cars, for example, don’t last forever. You’ll eventually need a newer car. So, you should pretty much always have a sinking fund for a new car.
Other things can sneak up on you. What about Christmas? The holidays can be super expensive. How about saving up a few months before Christmas? What about that new smart phone? Instead of leasing one for a monthly fee that charges interest, set aside a few dollars a month until you’re ready to make the purchase. Once you get ahead of purchases like this once it’s easy to stay in the positive. Trust me, it feels much better to pay yourself a payment than it does to pay the credit card company or leasing company.
When Not to Use a Sinking Fund
Don’t keep a sinking fund for purchases that could simply be cash flowed out of a single paycheck. These funds are to be used for items that require saving over several months. If you want the item bad enough and can pay for it from extra money in your budget just do so and move on. Just make sure it doesn’t eat into money needed for essential budget items.
Where To Keep a Sinking Fund
The bank. Done. Okay, just kidding. I’ll get a little more detailed than that. I suggest keeping a sinking fund in a savings account wherever you bank. I always recommend banking with credit unions. They charge less fees and, through the CO-OP network, have more locations than any major national bank. Smaller recurring expenses can be combined into one savings account. For example, we keep all our recurring annual expenses in one savings account (annual auto insurance, life insurance, membership dues, vehicle registrations, etc.)
For a larger purchase you may want to set up a separate account for that single item, e.g. we keep a separate savings account for vacations or the purchase of a vehicle. Most credit unions don’t charge to open a savings account. So go ahead and open a separate account for that car or that dream vacation.
Where Not to Keep a Sinking Fund
A sinking fund is not an investment. I repeat, it is not an investment. It is to keep other money freed up so you can invest (and keep you from incurring debt) but the fund itself should not be invested in mutual funds or stocks. Because of the relative short timeframe of most sinking funds it would be risky to keep them in investment accounts that could go down. Imagine saving for that desired item and the market goes down just before you’re supposed to make the purchase. No fun. Don’t try to get fancy; keep the money in a simple savings or money market account and don’t risk it.