What You Need To Know About a Sinking Fund

We all have something special we’d like to buy for our home or in life. That old couch that has seen better days in your living room begging for a replacement or a vacation you thought about for a long time but keep pushing off because it is too costly. Paying for these significant expenses can be challenging, but a sinking fund may pave a better way.

Sinking funds can be a gamechanger for individuals and households. It is a valuable tool to add to your financial toolbox for savings. This strategy helps those who want to manage their finances better and gain peace of mind.

The timing for setting up sinking funds could not be better. Americans have been saving more, as illustrated by the US personal savings rate of 14.9% for May 2021. The unusually high rate due to pandemic-related spending constraints compares to 7.6% at the end of 2019. So why not make your savings work better for you?  Setting up a sinking fund is easy to do and enhances your ability to save money for large purchases you will make in the future.

What Is A Sinking Fund?

Sinking funds have long been helpful for companies and bondholders to minimize risk. For example, when corporations need to raise capital, they may issue a bond that matures in 20 or 30 years. Bondholders receive coupons semiannually and the principal (their investment) at maturity.

Many bonds now have a sinking fund managed by a trustee who oversees the fund. Money is set aside periodically with a trustee for repayment of the portion of the principal. This action eliminates the need for a significant cash outlay for the company at maturity.

There is less risk of the company defaulting using the fund if it doesn’t pay back the principal to bondholders. The fund adds protection and security for the bondholder that the company can pay off their debt. A sinking fund allows a company to raise capital with a lower interest rate to bond investors. As such, it improves a company’s creditworthiness.

A Sinking Fund For Your Household

Similarly, you or someone in your family can create a sinking fund, dedicating a savings account for a specific household expense that may be too large to handle without borrowing the money. We will explain later how your sinking fund differs from your emergency fund.

Once you determine what you want, say a new couch for $1,000-$1,500 for your living room, your sinking fund is for the sofa, not for another expense. You intend to save money to buy a couch, making monthly contributions to the “couch” sinking fund. Everyone has their budget, lifestyle, and timeframe for getting the couch or whatever it is you are targeting.

With a bit of planning, you can have what you need or want in your life without guilt. For example, if you have your heart on a particular $1,500 couch within a year (i.e., 12 months), your monthly savings goal is to contribute $125 to the sinking fund each month. Then, break the estimated spending amount into the monthly savings you plan to deposit into the respective savings account.

There is a greater temptation to pull out your credit cards for these large purchases without a fund. Your challenge is that you would have to pay your card balance in full or face a card balance growing on a compound basis at high-interest rates. There are more benefits to setting up a sinking fund for purchases than the downside of adding to your debt.

Sinking Fund Vs. Emergency Fund

Both your sinking fund and emergency fund are safety nets but for different purposes. An emergency fund is for the money you set aside in a savings account for unexpected costs you may face when losing a job, boiler breaks, a medical necessity, or pet surgery. Emergencies, by definition, are unknown as to timing and amount needed. You still have to pay bills, rent, or mortgage. Unplanned events happen, upsetting your finances. We recommend having your emergency fund cover six months of your basic living needs. You want to have access to liquid assets quickly.

The sinking fund is for saving money for a known purpose you expect to purchase in the future. Typically, your sinking fund is for a specific planned amount. You know its timing and have been saving for it. The point of having a sinking fund is not to tap your emergency money or a general savings account.

Like you have loans for a house, car, and college, you are earmarking savings for larger items you want to purchase. Dollars are fungible and can go into a “car or house down payment” sinking fund. You can have a sinking fund by categories such as a house, car, vacations, Holidays, Christmas gifts, or charities. Alternatively, you can have sinking funds by being more specific:

• Kitchen remodeling
• Sofa
• Flat-screen TV
• Refrigerator
• Car maintenance and repairs
• Down payment for Car
• Down payment for House
• Pet bills
• Taxes
•  Vacations

Labeling the sinking funds is a personal decision based on your household and its relevant savings goals.

How To Set Up Your Sinking Fund

1. Review Your Budget

Before setting up your sinking fund, you should a good grasp of your household’s budget. Budgeting is an essential tool for understanding your income sources less fixed and discretionary expense categories. Fixed living costs include your rent or mortgage, utilities, loan payments, and savings. It would help if you had “savings” on your budget for paying yourself first. Depending on how granular your budget is, you should separate line items for an emergency fund and the sinking fund. Then, pick a budget method that works for you.

When it comes to fixed costs,  you have less flexibility to reduce amounts. But, on the other hand, discretionary spending varies based on money left over.  You can learn more about different budgeting approaches here.

2. List Your Planned Purchases

Please make a list of sinking fund categories, break them down into more specific items. Then determine the target amounts for each. Name your sinking fund by its discreet type. Some funds may have higher amounts and longer timeframes. Divide each type total by the numbers from the planned purchase time. For example, if you are saving up for a new car’s down payment in two years, estimate the cost of the car is, say, $38,000, so you would want around a down payment of  $4,500. That equates to about $190 of the planned monthly contributions for two years or 24 months.

There is no set number of sinking funds, though I would caution you about managing too many sinking funds.  This process is about organizing your finances to make things more effective and efficient for you. As in the sinking bond for businesses, you are the trustee or manager of the funds.

3. Where Your Savings Will Go For Purchases

You can open an FDIC-insured saving account for each type or have one large sinking fund named sub-accounts. Keep in mind that the sinking funds are separate from your emergency fund and savings accounts. The type of accounts you should look for should be readily accessible and liquid, similar to the account you use for an emergency fund.

When you open a sinking fund for each type, your accounts differ from target amounts and timeframe. For example,  when you are saving money for a house makeover or a down payment for buying a home, you probably are looking to build a five-figure money chest. If so, you can look for higher-yield savings or a money market account. On the other hand, for smaller purchases and shorter timeframes, avoid accounts that require minimums that penalize you with fees for not maintaining a specific balance.  Essentially, you want safety and liquidity for the sinking funds.

Use Sub-Savings Accounts

Some banks, such as Ally, allow you to have a savings account and sub-savings accounts when you have multiple savings goals for concrete purchases.  You can automate transfers to each of your sinking funds based on varying monthly contributions. Having the ability to transfer money can ease the process for you. However, you will be receiving more monthly statements.  Consider the account details regarding fees, minimums, if APYs are different, and whether this works for you.

4. Need FDIC-insured Account

Whatever you decide to do, each sinking fund should be in an FDIC-insured savings account that is readily accessible. Then, for longer-term purchases, look for higher yields and minimize fees you may have to pay.

Benefits of A Sinking Fund

1. Better Budgeting

When you have a good understanding of your budget, your fixed living costs, it is easier to plan for discretionary spending. You can decide what amount you can contribute to your specific sinking fund each month without becoming a hardship.

The better your budgeting, the better you can plan for your savings goals and spending. It is easier to save money when you have an intended target to set money aside for that purpose.

2. Conscious Spending

When you set up your sinking fund, you essentially are planning to buy something you need or want for your home or life. It is an act of conscious or mindful spending when you are intentionally saving for something. You know the specific couch you will buy, have a plan, and focus your attention on that couch.

Taking the time and doing comparison shopping makes it less stressful and more enjoyable to anticipate the arrival of something new that you specifically want to get. You are not at that stage where salespeople will push you into an impulsive purchase you’ll regret. Instead, you are more in control of your spending and more likely to negotiate where and when possible.

3. Delays Instant Gratification

The need for instant gratification is all around us, with social media ads tinkering with our brains. Unfortunately, the present bias plays a significant role in our leaning toward immediate pleasures. It causes us to favor the present over the future with immediate rewards. With effort, you can counter tendencies to overweight decisions that can cause overspending with planning.

With your sinking fund in place and growing closer to your spending goal, you can delay instant gratification. You have your mind not just on your expected purchase but on other things as well. Setting goals for one part of your life makes you more purposeful about your needs and wants. Achieving something on your list can be very fulfilling.

4. Avoids Adding Debt

Overspending can lead to higher debt, significantly rising credit card balances. Card balances are especially higher cost and challenging to handle. As in the sinking fund for corporate bonds, a household sinking fund can help us avoid reaching for our credit cards to pay for large ticket items. Increasing our monthly savings by earmarking money to contribute to a specific account that earns interest is the path to better financial health.

Saving first, spending later, and avoiding debt where we can, can improve our creditworthiness.

5. Peace of Mind

Having peace of mind is priceless. While you may not get rid of every stress you have, planning out expenditures for important things you want to get or do can help your mindset.

Drawbacks

1. Don’t Have Too Many Sinking Funds

You may get good at organizing your finances. The next thing you know, you have too many sinking funds, overlapping purposes. That reminds me of an ad for Post-It notes, stating that they should be used “for the little things you’ll forget,” and then you see yellow Post-Its all over people’s foreheads. You get the picture. You don’t want to create chaos. The sinking fund process should help to organize where your savings should go.

2. Sinking Funds Are Not Interchangeable

When creating sinking funds, they are separate from each other. Keep contributing to each based on the estimates you determined. Try to label them as discreetly as possible, so it is not confusing to you. For example, if you wanted a couch and estimated $2,500 for it, but found the one you love for $1,800, then you can reallocate your savings to other areas. Sometimes you under or overestimate the expected cost, so make changes but don’t blur the lines.

3. Keep Emergency Funds Separate

Having an emergency fund is essential, and its purpose is different from any sinking fund. Don’t transfer funds from your emergency account to your vacation account. That’s cheating, and if an emergency arises, you want that fund to be there for you in its safe and sound place.

4. Don’t Forget Savings For Other Goals

Saving for retirement and investment accounts is vital for your long-term future. Make sure to automate contributions to your 401K retirement plan, if sponsored by your employer, and for your Roth IRA. In addition, you should contribute some of your savings to investments, whether you are managing the account or have a financial adviser to do so.

Over the longer term, these accounts grow faster than savings bank accounts, depending on your respective investments (i.e., stocks, bonds, real estate), and benefit from compounding growth.

This article originally appeared on Wealth of Geeks and has been republished with permission.