Money Infant

Baby Steps to Financial Freedom

Sinking Funds for the Win(dfall)

I’ve recently talked about automatic bill payments and automatic savings, but there is still one area that you should really consider automating and that is your sinking funds. In case you aren’t familiar with sinking funds, let me give you some background and clarify what they are and why they are great for your household finances.

A sinking fund in personal finance is a fund set up to pay for large purchases in the short to medium term (usually 6 months to 5 years). They can be used to save for Christmas, vacations (think of the old bank Christmas and vacation Clubs), down payments for homes, a car purchase, home renovations or pretty much anything that requires more than a few months to save.

It is likely that even if you don’t know what a sinking fund is you already have one. The largest (and longest term) sinking funds are your 401(k), IRA and other retirement accounts. Think about it. You are saving on a regular schedule for an expense in the distant future and once you start using those funds they should fully fund the object of savings, in this case your retirement.

Sinking funds are actually pretty old, having originated in Italy in the 14th century. At that time they were set up by commercial tax syndicates and were used to retire the public debt of the cities represented by those syndicates. They were also used quite successfully in the early 18th century in Great Britain to reduce the government debt.

Technically the term sinking fund doesn’t refer to personal or household savings, but is a term used to describe the funds set up by governments and businesses that have the purpose of retiring that organization’s debts. Typically this means repurchase of bonds. The money for the sinking fund traditionally comes from the budget surplus, although in modern times budgets are created with the intention of funding these sinking funds to reduce credit risk for the organizations creditors.

So, how does all this apply to you? Simple really. Each year so many people go into debt paying for Christmas, taking loans on cars, charging family vacations on credit cards and the like. With a sinking fund in place none of this is necessary. All of these expenses are known in advance and can (should) be planned for by creating a fund for them. Many people ignore creating a sinking fund because psychologically they consider it an expense, which it really isn’t as long as you are building up the fund. Think of it as part of your savings and maybe it won’t be as painful psychologically.

The logical time to add one (or more) sinking funds to your budget is once you have your emergency savings at least ½ funded. The reason I say 1/2 funded is that funds can actually do double duty as emergency funds if necessary until your emergency savings are completely funded. Once you are at 1/2 your yearly emergency fund start to split that money and send 1/4 to 1/2 of it to your sinking funds.

You may not be able to fully fund a shorter term fund like Christmas by the time the holiday rolls around, but if you have something put aside it gives you options. You can go ahead and spend as normal knowing that at least part of your holiday spending won’t be more debts on your accounts. Or the preferred method would be to simply budget your spending based on what you have already saved in the sinking fund. I know this may seem painful to some, but if you want to get off the debt treadmill it is sometimes necessary to make small sacrifices.

Where you keep the sinking funds is completely up to you. When I first started using sinking funds I liked to have a separate account for each fund. It was easy for me to “see” my money this way. Now I have one account and keep track of the portions of that account that are earmarked for certain activities on a spreadsheet.

Here’s another bonus you can get from sinking funds. Once you have the necessary funds saved for your purchase see if you can get into a frugal mindset and spend less. For example, we often make aggressive projections when saving for both Christmas and vacations, but when the time rolls around we will look for deals and specials and typically save 10-25% off what we had projected. Booyaaa! Windfall for us.

I know it isn’t really a windfall since it is money we saved ourselves, but I can tell you it certainly feels like a windfall. And I love seeing the nice boost it gives to our savings (or debt repayment if necessary). Or you can roll it over into next year’s sinking fund if that makes you feel better. It still amounts to the feeling of a small windfall since you have now freed up some of the money you were using to fill up that fund. Can you say increased cash flow with me?

Honestly the sinking fund has numerous uses. Currently I use it to save for our future expenses. Because Thailand requires me to have a certain amount of cash in country to satisfy my visa requirements I simply created a sinking fund where I save 6 months living expenses. Once the funds are there I transfer them to Thailand and there’s my “income” for the next 6 months. It’s kind of like a rolling emergency fund in that I know at anytime I have anywhere from 12-18 months living expenses saved between my funds in country, my sinking fund and my true emergency fund.

Are all of you using sinking funds to save for your long term obligations (aside from retirement accounts). If you’re not what is holding you back? Did you not know about sinking funds or are you not in a position to use them? C’mon folks, talk about your money!

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2 Responses to “Sinking Funds for the Win(dfall)”

  1. Modest Money says:

    I think sinking funds are especially important for people who have the tendency to just put big purchases on credit. In the long run they end up paying far more as the interest starts racking up. A sinking fund actually helps motivate you to save more as you can watch your savings grow as you get closer to your goal. I’ve used it for a car down payment in the past and now I have one going for a mortgage down payment.

    • I agree, they are a huge help in avoiding high interest credit card debt. I’ve also found that as the savings increase it can motivate you to save more and reach your goal faster.

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