Do I need a sinking fund in my budget?

A secret weapon against blowing the budget

So you have been sticking to your budget diligently, but all of a sudden your dishwasher goes out or your pet needs an emergency visit to the vet.

Odds are you have been in this scenario before and it sometimes can take your financial journey down some long and strenuous detours. Unforeseen expenses are (sadly) a part of life that cannot be ignored. Taking some time now to help prepare for them can ease your burden when they do decide to pop up. A simple solution to help is by employing sinking funds within your budget. The good news? A sinking fund can be used in any budget and can be customized to fit how you need. Below, we will find out what a sinking fund is, if it is something worth your time, and how to create one.

What is a sinking fund?

To put it simply, a sinking fund is a bucket a money you have set aside to help prepare for larger expenses that are not recurring on your budget. By putting aside some funds in regular intervals, you can cushion the blow once large expenses hit. Normally, any funds you want to attribute to the sinking fund would be a part of your savings category; but now it has been earmarked for a specific use.

Who might find a sinking fund helpful?

Sinking funds can be useful for people who have been discouraged in the past by having large expenses wreck their budget. It can be disheartening to stick to a budget only for an unforeseen expense to completely ruin your month. This can lead to “doom spending”, which is a concept of spending more money as we get anxious. Doom spending is a hard feeling to crack (something I say from personal experience) and with some simple planning, we can try to mitigate against it. That is why in my personal budget, I utilize sinking funds to help smooth my budget over from random expenses that come up.

In full transparency, anyone who is able to regularly put money within savings on their budget can (and should) utilize some form of sinking fund. They are incredibly customizable and can be adapted to fit what need you have.

Creating a Sinking Fund

To make the most out of a sinking fund, spend some time to really think through what will realistically happen. A sinking fund, budget, or truthfully your entire personal finances will only be as useful as they are realistic. As we go through the steps below, make sure you are confident and comfortable with what you write down. That doesn’t mean you are 100% accurate (we never are), but it means you prepared to the best of your knowledge.

Identify the type of Sinking Fund you need

You can categorize your sinking fund into one of the following four quadrants. I would say if possible, try to move your sinking funds into a “known” category. By setting a realistic figure to use, multiple studies have shown you are more likely to stick to the goal.

Near-Known

These are the short-term oriented goals where you can reasonably predict the price tag. Think of the below example:

Maven has a friend getting married in Mexico in 10 months. After some planning, she puts together a little vacation budget and determines it will cost her around $1,500 for all expenses.

Maven has a reasonable guess on the budget and it is within 3 years, so she should plan according to a near-known sinking fund.

Near-Unknown

These are the short-term oriented goals where you cannot reasonably predict the price tag. These can range from car maintenance, medical expenses, home maintenance, etc. These are more preventative than anything, because if we were aware of the expense we could work to fit the fund in Near-Known (which is a better quadrant to be in)

Far-Known

These are the long-term oriented goals where you can reasonably predict the price tag. Think of the below example:

Duncan has never been impressed with the bathroom in his house. He does some research and figures it will cost around $7,000. He doesn’t have the money to do that now, so he sets a goal to save enough in 4 years to redo the bathroom.

Duncan has a reasonable guess on the budget and it is over 3 years, so he should plan according to a far-known sinking fund.

Far-Unknown

These are the long-term oriented goals where you cannot reasonably predict the price tag. The best example of this would be retirement (well until it isn’t far anymore…).

Determine/Estimate the cost and time of the fund

In both of the examples used above, Duncan and Maven estimated the cost and time of the expense to the best of their knowledge. This can help make the goal more achievable and optimize the savings vehicle you can use for your project.

It also can be just a rough draft as well. Let’s say in Maven’s example she just used Reddit to determine the average cost of a trip to the city she is traveling to. Maybe Duncan had a contractor come out and give him an estimate. There is no wrong or right way to determine where your fund will fit, as long as you feel comfortable and confident with how you got there.

Tips for Determining Time

Some of these funds may have a very tight deadline (such as in Maven’s case) or can be pushed in either direction (like Duncan’s case). Usually a tight deadline is given to you from an external force, so not much you can do about that! For a deadline that might be pushed, make sure to hold yourself accountable. Duncan may want that bathroom to be redone within the year, but if he sets an unrealistic goal he might get frustrated and give up. Instead, by setting it up as a 4 year goal - he knowns a much more manageable amount to save monthly that he can then overcontribute to and maybe reach the goal early. Make sure before you set this fund in motion, you have given yourself a timeline you feel is reasonable.

Tips for Determining Expense

For the expense itself, first acknowledge that you might not be able to get down to the dollar what it will be - and that is totally okay. If you are someone who is fearful of spending more than you put in the fund, maybe build some buffer in your initial planning just in case.

I find that usually some quick browsing on the internet can give me a figure to start with. Depending on the expense, that might be enough for me to work on. If it is a larger expense, or one that I can’t “underbudget” for, I might spend some more time writing down a line item budget. If Maven felt this way, she might research the price of a plane ticket, lodging, and meals. She also could add a cushion as well if she needed to be conservative.

Set in motion the monthly savings

The last step is to set in motion diverting some money from your regular savings into the sinking fund. For known funds, this is as simple as taking the total cost divided by the total amount of months you need to save for. For unknown expenses, maybe we can make a “target” amount you want to carry in the fund. Another route would be to transfer each month whatever you feel comfortable with out of your savings. Below are two common places to set up a “homebase” for your sinking fund.

Savings Account

This could be as simple as just having your savings account broken up into “buckets”. These buckets could be manual (you keep track of it yourself on a paper or document) or automatic (some banks have features that will split your money out within the account).

Another option is to create a separate savings account for your goal. A good option if you want to try to make some interest off the savings might be a High Yield Savings Account (HYSA). I would recommend using this if the goal is either a large amount or you find you need the separation to make sure it doesn’t get touched.

Brokerage Account

These are accounts that you hold at investment firms (Fidelity or Etrade for example). I would only recommend using this option if you feel comfortable investing. There is risk that comes with a brokerage account, but if the timeline is long-term; you can harness the power of compound growth (which is similar to compound interest).

If you don’t have much risk appetite, try setting up a regular investment into a bond ETF. If you make regular investments, and the timeline is long-term; you have better odds of reaching a positive ROI (Return on Investment).

All investments carry risk though, and not all funds need that extra risk. If you do not feel comfortable with using a brokerage account for your goal there is no problem with that. A bank account is a great choice as well.

Setting up automatic transfers

If your budget is in a comfortable enough position, another route you can head down is to set up automatic transfers. This makes one less thing for you to worry about and adds a layer of accountability to the goal!

Can I have multiple sinking funds?

Of course! I would advise starting slow with maybe one or two at first. See how they individually fit in your budget before you add too many. Once you do feel comfortable, a milestone in your journey could include having an emergency fund to cover unforeseen expenses (because what is an emergency fund if not a larger sinking fund?).

I currently have around four sinking funds I am working with in my personal life. An emergency fund for unforeseen circumstances, a house projects fund, a vacation fund, and a more long-term geared fund that I throw some extra money in if I can.

Removing a sinking fund once it has met its purpose

Some sinking funds might go in perpetuity as you draw down and build back up, but others have a limited shelf life after they accomplish their mission. Feel free to remove these from your monthly budget once they have reached their purpose and use the remaining funds (if there are any) however you feel fit. Maybe they go into other funds, general savings, treat yourself, etc.

Whether it is their ability to help cushion unforeseen expenses or reach financial goals you have, sinking funds can help smooth the path of your financial journey. It can be difficult but sticking with it can be extremely rewarding. Have you found success with sinking funds before? Let me know below!