Sinking funds are one of the best tools we have at our disposal to break the cycle of living paycheque to paycheque. As useful as it is, however, a lot of people haven’t even heard of them. In this article, we’re covering all the ins and outs of this personal finance game-changer. What are they? How do they work? What are they used for?
What is a sinking fund?
Put simply, sinking funds are a category of savings. Its purpose is to help keep your budget in check by putting money aside for those infrequent yet costly payouts. Here’s an example. Annual insurance payment coming up? If you’ve prepared a sinking fund, you’re all set! No need to go into debt or live on mac and cheese for a month to cover the payment.
How does it work?
Sinking funds are easy to set up. All you need to do is take the cost of the item you want to cover and divide it equally by the number of months there are between now and when the payment is due. Let’s say the annual insurance payment mentioned earlier is $1,500, and there are 11 months until the payment is due. That means by setting aside $136.36 ($1,500/11 = $136.36) a month, you’ll have enough money to make you’re payment.
What can sinking funds be used for?
There aren’t any hard and fast rules as to what a sinking fund can be used for. They can be used for anything. You can even have multiple sinking funds, as many as your budget will allow for. Below are some of the most common things people use them for:
- Celebratory events (birthdays, weddings, etc)
- Home repairs or renovations
- Pets
- Car repairs or maintenance
- Clothing
- Beauty & grooming
- Technology (new phone or computer)
- Subscriptions
- Vacations
What’s the difference?
A sinking fund may sound similar to other savings funds, like an emergency fund, but there is a distinct difference.
Sinking fund vs emergency fund
The main difference between a sinking fund and an emergency fund can be summed up with one word: expected. A sinking fund is used for expected expenses. They’re usually infrequent; you may not even know the exact date, but there’s no doubt the expense will occur. For example, you may not know exactly when your car will need new tires or when your cat will need to visit the vet, but these things will certainly happen eventually. When they do, having a sinking fund ready is really helpful.
On the other hand, an emergency fund is for those times when financial challenges or obligations happen unexpectedly. Typically, these occurrences require more financial backing, too. A good example is the loss of a job.
Investment savings
Investment savings, such as RRSP and TFSA, differ from sinking funds in that they are much more of a long-term goal. Sinking funds are more of a mid-term goal and are typically geared towards a very specific purpose rather than overall income potential.
Benefits of using sinking funds
Saves money
Sinking funds save you money. It’s easy to see how, by going back to the annual insurance payment example. By not using credit, you avoid adding interest costs to the payment. You also save costs because annual payments are often cheaper than paying by the month.
Leaves your emergency fund untouched
Planning out a sinking fund leaves your emergency fund intact. Something you’ll be particularly thankful for should an emergency happen at the same time you have a big expense obligation.
Less stress
Sinking funds help relieve a lot of the stress around finances. Even just having a plan in place to cover an expense coming up can go a long way to reducing stress. No more overwhelming feeling of dread about how you’ll be able to pay, and, ideally, no stress when the day comes to pay. It becomes just a matter of the swipe of a card or handing over cash.
Motivational
Research has shown that knowing a specific end time for a goal makes it easier and more likely for people to achieve that goal. A sinking fund’s innate nature of having a specific goal and timeframe helps people stick to their plan. Seeing your savings grow can also be very motivating.
Level up your financial literacy skills
Planning for sinking funds is a particularly good financial literacy practice. By nature, they get you to think outside of your everyday spending patterns and into the future. They get you asking, “Where do I want my money to go?” It’s this approach to personal finances that puts you in the driver’s seat of your wallet instead of your money and bills leading the way.
Where to put the money
There are a couple of key considerations to take into account when deciding where to keep your sinking fund. The first is accessibility. You want to be able to get at the money when you need it, but leave it just far enough out of reach that you’re not tempted to spend it until the time is right. The second is interest. While your money is sitting there waiting to be used, it might as well be working for you and earning more money. A High-Interest Savings Account fits both these criteria really well. That being said, having a sinking fund at all is more important than where you keep it.
Best practices
Set up an auto transfer to move your money into your sinking fund. This will lessen the chances of forgetting or being tempted to spend it instead.
When you’re done with one sinking fund goal, consider putting the funds you were using for that goal towards another goal instead of adding them to discretionary spending. This will help you continue to live within your means and avoid lifestyle creep.
Wrap-up
Sinking funds are a really effective and easy way to stop busting your budget. As a result, they lessen stress, increase financial literacy, and help reduce debt. If you’ve been struggling with a lot of debt, our trained Credit Counsellors can help by going through a personalized debt management program. Call for a free consultation!
