Sinking funds are tools that people or businesses can use to set aside money for a planned expense. For instance, you may know that you want to take a vacation next year, so you may start putting cash in an envelope in order to save up for that vacation. That, in effect, is a sinking fund.
Sinking fund categories, as such, depend on the expenses relevant to each individual. They can include auto repairs, health care costs, gifts, insurance payments, vacation funds, and more.
You can think of sinking funds as a way of “sinking” your money into an account for later use. It’s basically a savings strategy. We’ll get into it more below.
General Definition of Sinking Funds
The term “sinking fund” has its roots in the world of corporate finance, but mostly refers to the way that an individual would utilize them: for setting aside money or various types of income for a future expense.
Sinking funds are smaller offshoots of an overall budget. Putting together a sinking fund entails stashing money in reserve for the future, knowing what that money will eventually be spent on.
For instance, some people like to pay their car insurance in six-month installments. They may sock money away each month in anticipation of the next six-month installment payment, so that they’re not hit with a big expense all at once.
Their car insurance sinking fund contains the money they need, so they don’t have to scramble to cover the cost every six months.
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Examples of Sinking Funds Categories
When it comes to sinking funds categories, there are no hard and fast rules. Different individuals have different financial needs and planned expenditures. As such, their sinking funds categories are going to vary. That said, some common sinking fund categories are applicable to most individuals. Here are some examples:
• Vacations
• Gifts and holiday-related expenses
• A new vehicle or regular maintenance and insurance costs
• A home purchase or home maintenance expense
• Medical and dental costs
• Childcare costs
• Tuition expenses
• Pet expenses, such as veterinarian visits
A sinking fund can be helpful in saving for just about anything.
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Sinking Fund Category Calculations
Setting up a sinking fund is easy enough: You can stuff cash under your mattress or use a savings vehicle like a savings account. The difficulty for most of us comes in regularly contributing to it. But the trickiest part may be figuring out how much you should be contributing.
A budget planner app can come in handy, as you’ll be able to see how much money you have to dole out to your sinking fund categories after your monthly expenses have been taken care of.
Similarly, if you stick to a certain budget type — such as the 50/30/20 rule — that may help determine what you can contribute.
To calculate how much you can contribute to a sinking fund, first you’ll need to decide which sinking funds are the most important. Another consideration is which fund will need to be utilized first — perhaps you have an auto insurance payment coming up before a vacation. Priorities and timing both affect your sinking fund calculations.
In corporate finance, there is an actual sinking fund formula that helps a company figure out how much it needs to put away to pay off a long-term debt in a lump sum, while paying minimum amounts in the meantime. This can apply to individuals, too.
The formula looks at the amount of money already accumulated, multiplies it by any applicable interest, then divides it by the time period remaining on the loan. Using this calculation can tell you the monthly amount needed to be contributed to a sinking fund to reach a debt-payoff goal.
For individuals, however, it can be as simple as looking at your monthly income and dividing extra cash accordingly into your sinking fund categories.
Types of Sinking Funds
How do you save up a sinking fund? There are a few savings vehicles you can utilize.
The most obvious, and probably the simplest, is to keep the sinking fund in cash, and store it somewhere safe. Of course, that money won’t be earning any interest, and will likely lose value on an annual basis due to inflation, but it’s one way to do it.
Perhaps the best and safest option is to open up individual savings accounts at your financial institution for each of your sinking fund categories. This beats cash because your sinking fund is protected (and insured up to $250,000 by the FDIC), and you will earn a little interest on it, too.
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Best Time to Take Advantage of Sinking Funds Categories
Sinking funds are all about using time to your advantage, by saving up for a planned or known expense well ahead of time. As such, the best time to take advantage of them is when that expense finally does arrive, be it a pricey vacation, a new car, or sending a child to college.
There may be times or periods during the year when it’s more advantageous to save than others. For instance, most people experience a financial crunch during the holiday season — there are gifts to buy, parties to attend, and other demands on your income. So that may not be the best time to “sink” money into a fund.
Instead, think about when you may have some extra money, such as when you get a tax refund or receive a cash gift for your birthday. Those are the times when you may want to add something to your sinking funds.
The Takeaway
Sinking funds are designated cash reserves for future expenses. Using a sinking fund means that you’re stashing money away for an upcoming, known expense, and relieving some of the financial pressure of that expense ahead of time.
Sinking fund categories can vary, depending on your individual situation. Corporations and businesses also use sinking funds.
Sinking funds are a way to get ahead of your planned expenses, and give yourself some financial wiggle room. A money tracker app can help you do the same.
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FAQ
What to put in sinking funds?
You’ll put cash in a sinking fund — cash to use on an upcoming expense at a later time. What that expense is (i.e., a sinking fund’s category) will vary depending on your specific financial needs.
What is a sinking fund leasehold?
A sinking fund leasehold contains funds for repairs or renovations to a rental property. The leaseholder or landlord sets aside a small percentage of the rental money collected every month to build up the fund.
What is the difference between a reserve fund and a sinking fund?
The two are more or less the same. The big difference is that a sinking fund’s contents are designated for a specific purpose or expense, whereas a reserve fund contains funds used for general future expenses.
Photo credit: iStock/Delmaine Donson
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