What is a Sinking Fund?
Sinking funds are like savings pots. They are a key part of personal budgeting because they help to smooth out your cashflow each month. But what is a sinking fund exactly?
Personal budgeting has borrowed the term from the world of banking and business. It’s a savings strategy to deal with large bills that you’d otherwise have to pay by credit card or other debt mechanisms.
Say you want to pay for a big holiday and the cost is equal to a hefty chunk of one month’s income. Maybe your monthly income, after tax and other deductions, is $5,000 and the trip will cost you $3,000. If you set aside $250 a month from your income in a separate savings account, in a year you will accumulate $3,000 (maybe with a bit of interest on top). Then you can pay for the holiday without resorting to borrowing any money.
This holiday savings account is a sinking fund.
Why is it Called a Sinking Fund?
Back in 1716, the Bank of England put some surplus income into an account they called the Sinking Fund. They’d earmarked this money for special purpose. It was to pay down – to ‘sink’ – the country’s national debt (which was growing due to the expense of a war against the Dutch).
After this, accountants and organisations began to use ‘sinking funds’ as a label for monies set aside to pay off a specific bill that would full due at some future date. Just like with personal budgeting, they knew there wouldn’t be sufficient monthly income to pay the bills.
What is a Sinking Fund Example?
What is a sinking fund in terms of personal budgeting and how is it different from your general savings and investments? You use a sinking fund to save for a specific purpose. You calculate an amount to put aside each month to meet a bill you expect to have to pay at some future date.
You have various options for splitting personal spending into different categories. One option is:
- Goods or services you buy every month - you don't use sinking funds for these
- Items you buy less often - you may well use sinking funds for larger items
This second category – payments that crop up now and again – can be a big challenge because they can blow a hole in your monthly budget. Examples are:
- Festive gifts
- Holidays
- House repairs
- Annual subscriptions
What is an example of a sinking fund when it comes to personal budgeting? Just a simple savings strategy to build up the money to pay for items like these.
Do You Have to Open a Separate Savings Account for a Sinking Fund?
You can set up separate accounts, but you don’t have to.
You can use whatever method you like to save for these large bills. One idea is to use a separate account to items like holidays or Christmas, where you want to set a cap on your spending for the year. Also, for items like house repairs where you may not know how much you'll be spending, or when, but you're aiming to build quite a sizeable savings pot.
On the other hand, you could gather together smaller items into a single savings account. It would be a reserve, like an extra emergency funds account.
Your main mechanisms for your sinking funds are:
- A separate bank account for each sinking fund
- A single bank account with digital sub-accounts
- Cash (if you use the envelope method)
Imagine that you need to put aside $950 each month into your sinking funds. You’ve arrived at this figure by calculating the annual cost of holidays, estimated house repairs and so on, then divided each of those costs by 12 (months).
- Item 1 $500 per month
- Item 2 $200 per month
- Item 3 $150 per month
- Item 4 $50 per month
- Item 5 $50 per month
That could be five separate bank accounts, or five cash envelopes, or a single bank account with five digital envelopes. A budgeting App may do the job, too. If you prefer, you can use a single bank account, and keep a note of how much of the balance in the account relates to each item. I have tried this last option and found it to be too unwieldy. But it may work for you.
How Much Do You Have to Set Aside Each Month?
Some future expenses are predictable. You can make a good estimate of the amount and when you’ll have to pay them. It’s just the total divided by 12 months.
But, when you’re just starting out with sinking funds, you may not have a whole year to accumulate your sinking fund savings. For example, you may want to book a holiday you’ll have to pay for in seven months. If the holiday costs $3,000 and you had a whole year to save for it, that would be $250 per month. But if you have only seven months, you’d have to put about $430 into your sinking fund each month.
You will have other large bills that are less predictable in amount, for example medical expenses or house repairs. All you can do here is make a best estimate of how much to put aside each month.
Using Your Suppliers to Smooth Out Your Cash Flow
What is a sinking fund? It's just a method for smoothing out your cash flow, so you don't have to take on debt. If your income is $5,000 per month and you’re determined to live within your means, you don’t want to pay out more than $5,000 in a month. Or at least, if you pay more than your income, you want the money to come from savings and not a credit card or other borrowing.
You pay into your sinking funds each month to build savings for large irregular bills, so your income plus savings is always sufficient. No credit cards. No debt.
Some of your suppliers may be willing to accept payment month by month, which also helps. Insurance premiums, for example. You’d need to check the small print. Will it cost you more if you spread your payments over the year?
Spreading payment of an insurance premium isn’t debt, provided you’re paying the premium for each month you’re on cover. If you sold your house during the year, your insurance cover would end.
Sinking Funds for Beginners
Sinking funds - or savings pots – are vital for your personal budgeting. At first, they may seem like hassle. But saving in advance for large bills is the only way to live within your means without resorting to credit cards or other debt.