A sinking fund is a fund used to set money aside to fund/meet a future obligation. It is commonly used by big organisations to set money aside to repay obligations such as bonds. There are a lot of applications of the sinking fund method to personal finance. Applying the same concept, you can use your sinking fund to save for a future obligation.
I love using sinking funds to plan for one-off annual expenses as well as future expenses. It is also useful for budgeting as you can include the monthly equivalent of an annual payment/savings into a monthly budget. With the current cost of living crisis, it’s even more important to start planning your finances better by utilising sinking funds.
Still thinking of why you need a sinking fund, here is a summary of some of its benefits;
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What are the benefits of Sinking funds?
Pay large bills
If you have large bills or a large outlay such as a house deposit, a big holiday, a renovation, or a car that you want to cash fund. A sinking fund is a great way to plan and save for it.
Avoid debt
Buy now and pay later schemes are tempting right? Unless it is urgent, save now and buy later is the exact same thing in reverse. Planning ahead and saving for something ensures you don’t need credit schemes thereby avoiding debt.
Spread out the costs of a one-off annual bill
If you know you might need to change all your tyres close to when an MOT or even a car service is due, saving something like £50 a month into a car sinking fund is easier than paying a bill of £200-£500 from your monthly income. A sinking fund helps you save in small chunks for a known one-off large expense.
Plan and save for future expenditure in a low-pressure way
Similar to the above, if you do a bit of planning ahead of impending expenditure, you can save for it with a minimum intensity approach. For instance, if your current car is about 10 years old and showing signs of wear and tear and you believe it will last for 5 more years. Work out the monthly equivalent of the cost of the new car over 5 years and start saving. It means when the time comes, you are ready and you can make the purchase easily with no pressure.
Is it the same as an emergency fund?
The short answer is no, they are similar in the sense that they are both funds that you can use to cover expenditures. However, an emergency fund is for unplanned expenditures, while a sinking fund should be for known expenditures. There are some similarities, like an emergency fund, a sinking fund needs to be accessible if it’s for something you will need soon.
How to adapt the sinking fund system
- Decide on a savings account to use- keeping your sinking funds separate from your main account is a good idea. It reduces the temptation of spending your funds and you can seek to get the highest interest or returns for your savings. I use my Monzo account for my short-term sinking funds, Monzo allows you to create saving pots which help me manage my different sinking funds easily.
- Work out how much you need and when. For instance, if you need £12,000 to replace a car in 5 years. That equates to £2,400 of savings needed per year and £200 monthly. Add £200 savings for a car into your budget. I have a sinking fund section in my budget template which I use to budget and track various sinking funds. See snip below;
- Save the needed amount monthly and you are on your way to cash funding your annual bill, an event or a big purchase
You can download a free budget template using the form below;
Where to save your sinking fund
Where to save your sinking fund depends on your time horizon for the activity you are saving for. Funds needed in the short term can be put in an easy-access account. Consider opening a savings account and shop for one with the best interest rate available. A digital bank like Monzo is also a great option as it allows you to create several savings pots for your sinking funds. You can also set a savings goal and it will show your progress e.g. 50% of the savings goal met. The downside is they won’t have the best interest rates.
A notice or fixed savings account within your time frame will also be a good option as they pay a higher interest. The most important thing is to think about when you will need the money in other to get access to it easily as well as ensure the safety of your capital and possibly earn some interest.
If saving for a longer duration (over 5 years), you may consider investing in the stock market. However, choose your investments carefully because your capital may be at risk.