Learn all about what a sinking fund is, what it’s used for, and how to build one so you can save for your future today!
A sinking fund is a type of saving strategy that helps you save for the future now. It can be used for a million different things you want to save up for and helps you avoid using credit for large purchases. Instead of letting life events and large purchases increase your debts, be proactive about your finances and start building a fund for future plans now.
In this article, we’ll go over all about what a sinking fund is, how it works, and examples of all the many reasons you might find this personal finance strategy useful in your own life.
What is a Sinking Fund?
A sinking fund is a type of savings fund you build over time to eventually pay for a large expense or debt. It’s like a savings fund with a specific purpose, like paying for a new car, paying off a debt, or saving up the amount needed for a down payment on a house.
The term “sinking” means to fall or settle downward. The term “sinking fund” stems from this meaning in that it’s a fund companies use to “sink” or eventually pay a debt all the way down. Saving up this lump sum payment for debts is a debt repayment strategy that some companies will use to save money and avoid having to make a larger payment when the debt matures. Today the term is also used to refer to funds used to save up for a future expense and not only a fund to pay down debts in a lump sum payment.
This is a great way to save up for larger purchases you need or want. It’s a great saving strategy when there’s a purchase you want to make in the future and you want to plan ahead by putting together a savings plan for it now.
Sinking Fund vs Savings Account
A sinking fund is similar to a savings account in that they are both accounts where you save money. You might even use your savings account to hold your sinking fund. But a savings fund is different in that a sinking fund is intended for a specific purpose while a savings fund is more general.
A savings account can hold your savings for many things. It might be where you keep your emergency fund and your sinking fund for a new car. Or you might have a separate savings account for each savings goal you have.
However you organize your savings, a sinking fund is the amount you put toward a designated purpose, while a savings account is where you hold the funds.
Sinking Fund vs Emergency Fund
A sinking fund is similar to an emergency fund in that they are both a type of savings fund. But an emergency fund is money you saved up for emergency or unexpected expenses, while a sinking fund is money you saved up for a specific purpose, like a new car, a big vacation, or a home remodeling project.
So while they are both savings funds, they both have different purposes. A sinking fund is used to save up for a planned future expense while an emergency fund is used in case of unplanned future emergencies.
How to Build a Sinking Fund
Building a sinking fund is much like building any kind of savings or emergency fund. This fund will just have a very specific purpose for how it’s going to be used after you reach your goal total.
The first thing you’ll want to do is decide what you want to save up for, then set up a safe place to keep your savings like a savings account at a bank or credit union, and then budget how much you’ll put aside each month into this fund to reach your ultimate goal.
1. Decide what you want to save up for
The first thing you need to do is decide what you want to save up for. There are many things you could save up for, like a house, car, or a new TV. Anything you might want to purchase in the future that you don’t have the funds for right now.
What you decide to save up for could be big like a house, college fund, or retirement. But it could also be smaller like new curtains, a new phone, or a new gaming console.
2. Set up a safe place to keep your savings
The next thing you need to do is decide where you’re going to keep your savings. You want to choose a place that will keep your money safe and also separate from your everyday spending money.
A savings account is a great place to keep your sinking fund. This place also allows you to set up autopay so the money you want to set aside each month is put aside automatically.
You could also set aside cash each month in a safe location like a piggy bank. This could be especially helpful if you’re already using your main savings account for different purposes.
3. Budget how much to save each month
The final step is to budget how much you want to save each month to reach your ultimate goal. Look up the total cost of the future expense and then divide that total by however many months you have to save up. This will give you how much to save each month to have all the money you need in time.
Total Cost / Months to Save = Monthly Sinking Fund Payment
If the monthly sinking fund payment ends up being too much for your monthly budget, then you may need to decrease the purchase amount you’re looking to make or increase the number of months you have to save to make a more manageable monthly payment.
Sinking Fund Example
First, decide what you want to save up for. For example, maybe you want to save up for a new car. You do your research to find the car you want and determine that it will cost you about $24,000 total.
Second, set up a safe place to keep your savings. You have a savings account with your bank that would make a perfect place to safely put aside money for this future purchase.
Finally, budget how much you’ll put aside each month. This step is where you’ll need to do the most calculations. You’ll need to consider when you want your fund to be ready alongside how much you can afford to set aside each month.
Try using the following formula to determine when you can reach your savings goal and how much you need to budget to save each month:
Total Cost / Months to Save = Monthly Sinking Fund Payment
$24,000 / 12 = $2,000
If you want to save up $24,000 in the span of 1 year (12 months), then you’ll need to put aside $2,000 each month into savings.
$24,000 / 24 = $1,000
If you want to save up $24,000 in the span of 2 years (24 months), then you’ll need to put aside $1,000 each month into savings.
$24,000 / 36 = $667
If you want to save up $24,000 in the span of 3 years (36 months), then you’ll need to put aside $667 each month into savings.
Make whatever adjustments you need to this formula and your budget until you have the right monthly payment and timeframe for your financial goals. All that’s left to do after that is enact your plans and start saving until you have enough to buy the car!
Types of Sinking Funds
This type of fund is basically a saving strategy you can use for any planned expense you want to save up for. Anything that you want to spend money on that you can’t pay out of pocket right now, you could save up for with this type of fund.
Here are a few of the many things you might want to save up for:
- To save up for a new car or a car down payment
- To save up for a house down payment
- To save up for a planned vacation
- To save up for a birthday party budget
- To save up for a wedding budget
- To save up for your Christmas gift budget
- To save up for a home remodeling project
- To save up for new living room furniture
- To save up for a new laptop
- To save up for a new phone
- To save up expenses for a move
- To save up for concert tickets
By using a sinking fund, you are putting money aside for a few months or even years so you can afford a big purchase. That way, you won’t have to go into debt and make payments on the principal and interest on what you borrow. Instead, you’ll save up the money you need to afford that purchase without relying on credit or debt.
Benefits of a Sinking Fund
What is the purpose of a sinking fund? A sinking fund is a great way to pay for larger purchases without having to rely on credit cards and loans. If you don’t have the money to make a large purchase up front, start a sinking fund to save up for it instead of relying on credit.
- Avoid Debt: Save up for large expenses in advance to avoid taking on debt or loans to cover those costs.
- Financial Peace of Mind: Reduce financial stress when you know you have the money you need set aside and won’t need to take on more debts.
- Improved Budgeting: By regularly contributing to this fund, you can plan for future expenses without negatively impacting your monthly budget.
- Encourages Discipline: This fund encourages saving discipline by making regular contributions toward specific goals, helping you build consistent savings habits.
- Reduces Financial Surprises: You’ll be better prepared for planned expenses, like vacations, car purchases, or home repairs, making unexpected costs less likely to throw off your budget.
- Customizable for Any Goal: Sinking funds can be tailored for short-term or long-term goals, whether you're saving for a big vacation, a new appliance, or even holiday gifts.
- Helps With Cash Flow Management: By saving in smaller amounts over time, you can manage large payments or purchases without taking a large chunk out of your budget all at once.
- Earn Interest: If you place your fund in a high-interest savings account, you can earn interest on your money while you save.
- Improves Spending Awareness: Having a sinking fund makes you more conscious of your spending and helps you prioritize which large expenses are truly important.
- Increases Financial Flexibility: With sinking funds in place, you can cover planned expenses without having to dip into emergency savings or other financial resources.
