There's an often-overlooked component of the budget and that piece is called sinking funds. But what exactly are sinking funds and how does that work for your budget especially when your budget is already tight? In this post, we'll explore how sinking funds work and how you can go about funding your individual sinking funds.
What is a sinking fund?
A sinking fund is an account you create that is designed to be depleted over time. The purpose of this account is to fund a regular expense that you have that often is left out of your budget. Here’s what I mean: An example of a sinking fund is car maintenance and repair. It is often left out of the budget because we don’t know when exactly we will need to use the money. Instead, we are caught off-guard and may end up going into debt for things like new tires, oil changes, and repairs.
Instead of being surprised by these expenses, a sinking fund is designed to have money available for these things when the need arises.
Another example of a sinking fund can be a vacation fund. In this case, it acts more like a savings account because, when it’s funded, you’ll use it up. But it can be a separate checking account (more on this later). The money you need for your vacation will go into this fund and you will only use this money for your vacation.
You won’t pull from emergency funds or other sources if you truly don’t have to. These funds are sinking because their balance is designed to go down.
How to fund a sinking fund
Funding a sinking fund starts with figuring out exactly how much money you need to put in the account each month. While some experts recommend actual separate checking or savings accounts so that the money is truly separate, that may not be a good solution for you.
Instead, make sure you have a good spreadsheet, budgeting software, or good old-fashioned pen and paper to keep track of how much money you have in each account. If you set up separate accounts, be sure to set up automatic deposits so your accounts are funded each month.
Once you have set that up, it’s time to take a look at your irregular expenses. These are expenses you have that do not get paid every month. For example, if you only pay your car insurance every six months, then that becomes a sinking fund. If you have children who play sports, that can be a sinking fund.
Other popular accounts include accounts for holiday shopping, gifts, car maintenance and repair, and back-to-school shopping. As you get more familiar with your expenses, you’ll know what to add.
Next, let’s look back on the past 12 months of irregular spending. Take note of how much you spent in each category over the last year and come up with a total. After that, divide by 12 and you’ll know how much money to set aside each month to fund your various accounts.
What if I have an expense that the fund doesn’t cover?
This can be a tricky situation when you have an expense that you need to cover, but you don’t have enough in the sinking fund to cover it. What do you do?
First, use the money in the sinking fund, that’s what it’s there for. Next pull money from either your regular checking account, if you can, or from your emergency fund. Remember, you will have to replace this money because you have a budget and all of your money should be accounted for.
Your last resort is using your credit card. Try to avoid that as much as possible but I understand this may be hard in the beginning.
Sinking funds are a great asset to your budget because it accounts for those irregular expenses we tend to forget about. By setting up sinking funds, you will put yourself and your money in a better position to anticipate irregular spending and avoid new debt.