Want to relieve the stress of a large upcoming expense, like a roof replacement or car purchase?
Sinking funds reduce stress and preserve mental energy. They certainly make my Christmas more enjoyable. I show how later in this post.
A peak at Money Statistics shows that money is the #1 stressor in the US and Canada. Reducing stress and energy allocated to money decisions means more time and energy to put towards the important things in life. That’s why this blog exists.
In this post, I cover sinking funds, how to use them, and their top benefits.
What is a Sinking Fund?
A sinking fund is a savings account used to save cash for a specific upcoming large & irregular expense.
For example, I have a sinking fund for Christmas gifts. This fund is a High-Interest Savings Account (HISA). I sink money into it monthly. Come Christmas, I spend the money in the sinking fund.
How To Use A Sinking Fund
You “sink” cash into the account on a monthly basis for an upcoming expense. When the expense comes due, you spend the money in the sinking fund.
There are a few steps to use the sinking fund:
- Set financial goals. What expenses do you need to save for in the next 5 years?
- Find the right account to keep the sinking fund.
- Figure out how much to contribute to the sinking fund each month.
- Spend the money in the sinking fund. Yay.
In addition, you must know where to store the sinking fund.
When Should I Use a Sinking Fund?
A sinking fund should be used for upcoming irregular and planned expenses in the next 5 years.
The sinking fund isn’t useful unless you first know what you are saving for. Therefore, your unique money goals are the starting point. These goals must be written down and reviewed once per year.
It’s critical that you set aside the time and brainpower to sort out your money goals. These goals allow you to deliberately use your money to maximize your wellbeing. The sinking fund is only a tool to meet these goals.
Common examples of upcoming financial goals include:
- Annual vacation
- A downpayment on a house.
- A wedding coming up in two years
- Christmas gifts
- Renovations next year
- Driveway repaving next summer
How Much Do I Contribute To My Sinking Fund?
To find how much you need to contribute monthly, you need two pieces of information:
- The expense amount
- The number of months until the expense comes due
Monthly Contribution = (Total Expense) / (Months Until Expense)
For example, let’s say you have a $3,000 vacation coming up in 10 months. Every month, you need to sink ($3,000)/(10 months) = $300/month.
When it’s time for the vacation, the money will be there, ready to be spent.
Finally, interest rates can be considered for expenses further in the future, such as a wedding in three years. Rates become more important when interest rates are going up.
To find how much to contribute monthly, you can use this compound growth calculator. Put in your expected interest rate and trial and error monthly contributions to meet a final amount.
Where to Hold The Sinking Fund
Sinking funds are used for expenses upcoming in the next 5 years. Because this time horizon is too short for investing, sinking funds are best held as cash in a High-Interest Savings Account (HISA). A money market account is another option.
Finally, guaranteed Investment Certificates or short-term bond funds are other options for sinking funds with longer time horizons. The “placement” of your sinking fund depends on how far in the future you need the money.
Cash in a HISA is the best bet 95% of the time simply because it keeps things simple.
I talk in more depth about where to put short-term savings in my post Short-Term Savings: Top 4 Options To Meet Short-Term Goals.
Stocks and longer-term bond funds are off the table unless the purchase is further than 5 years in the future. The actual mix of stocks and bonds will depend on your time horizon and risk tolerance.
Sinking Fund Benefits
Sinking funds offer many benefits. They help you meet your money goals with less stress. But they also strengthen money habits, preserve your emergency fund and keep you invested.
Smooths Large Expenses Over Time
The sinking fund transforms a large irregular expense into consistent monthly expenses. They smooth your spending over time.
With consistent monthly spending, you now have consistent monthly savings. This assumes you have a stable income.
The smoothing effect keeps you saving and investing consistently. Saving and investing a similar amount each month builds strong saving and investing habits. It also helps you ignore market noise, preventing attempts at market timing.
Every Dollar Gets A Job
People who are good with money give every dollar a job. The sinking fund does just that. It helps you your money intentionally to meet specific goals.
Money has to be used deliberately to squeeze out maximum value. The same concept applies to all finite resources.
Sinking Funds Prioritize "Future You"
Personal finance (and life) is a balance between present you and future you. It’s you vs. you. Consideration of future you requires self-discipline. With this lens, budgeting is freeing rather than restrictive.
The Happiness Hypothesis by Johnathon Haidt captures this well. You need to protect yourself from yourself. Humility is a must to do this. Sinking funds help bring future you into the present-day decision-making.
Protects Your Emergency Fund and Investments
You rely on the sinking fund when a large planned expense comes due. That means you won’t do bad things such as:
- Dip into your Emergency Fund.
- Take on high-interest debt to fund the expense
- Dip into your investments.
You don’t steal from yourself and take on credit card debt with a 20% interest payment to fund a $4,000 vacation. Instead, use the sinking fund to avoid interest payments.
Likewise, you preserve your emergency fund to prioritize expenses that cannot be planned.
Finally, the use of sinking funds leaves your investments untouched. They can remain untouched to undergo compound growth over the course of decades.
Sinking Funds Categorize Money By Time Horizon
Your sinking fund contributions are based on when major upcoming expenses occur. Could be a car purchase in 2 years, a vacation this year, or a wedding in 3 years.
Sinking funds batch your expenses by time horizon.
This makes clear what money can be parked away for longer-term investing. Money that is not needed for the next 5-10+ years can be considered for investing. This stage is reached when you have zero high-interest debt, have an emergency fund, and have paid down sinking funds.
There is more to your readiness to invest. Check out this post on 9 Signs You Are Ready to Invest. Once that is done, you can read Invest In Index Funds for Canadians: The Ultimate Guide.
Sinking Funds: Spenders vs Savers
Sinking funds serve different purposes for spenders and savers.
Savers like me feel pain when we spend. I wasn’t able to save and invest much in the month of December due to Christmas gifts. I would get grumpy, and my enjoyment of Christmas would go down.
The use of XMAS sinking fund changed that. Now I save money monthly in my XMAS gift sinking fund. In December the money is sitting there for this specific purpose. I no longer get grumpy at Christmas time. The pain of spending is no more. Sinking funds improved time with my family.
A spender is different. Spending money doesn’t sting and often brings joy. The problem is spending too much money. The sinking fund ensures the spender has the money available. It prevents spenders from dipping into investments or taking on high-interest debt to finance upcoming expenses. The sinking fund protects the spender’s future.
Sinking funds help savers enjoy their money while it helps spenders ensure they actually have the money.
Sinking funds are a powerful way to help you save for upcoming large expenses in a stress-free way.
The top benefit is their smoothing effect that promotes consistent saving and investing. There is something nice about consistency.
The value offered by sinking funds differs for savers and spenders. They can help savers like me spend without inducing stress. For savers, the sinking fund ensures money is available. It protects their future.
I believe everyone should use sinking funds.