What Is a Sinking Fund and Why You Need Them?
We’ve covered a ton of strategies to help you shave just a fraction off your spending, given some ideas to help you combat that inner impulse spender in you, and even some ideas to make some money on the side. If you’ve gotten to know all of them, you’d have a pretty good picture of how to structure your finances. Heck, you might even end up with more than you first imagined.
But there is one more component to your financial planning other than your emergency fund and savings account — A sinking fund.
What is a sinking fund?
In simple words, a sinking fund is the money that you save each month towards something you want to spend on. These are things like birthday parties, vacation, or even renovation plans. What you don’t want to do is tap into your emergency fund or use your credit card.
A sinking fund saves you from having to scramble money together at the last minute because you’re already prepared for it.
Why do I need a sinking fund?
We can’t possibly know what’s going to happen in the future, for better or worse. But one extremely likely scenario is that we’ll be faced with an expense that is outside of our usual budget. Maybe a friend of yours is getting married, a typhoon swept the country, or if there was an amazing vacation deal that you can’t miss. That’s just life.
When you have a sinking fund, you’ll know that in case anything happens, good or bad, you’ll have some money on standby that is apart from your emergency fund. From the bigger picture perspective, you’ll have a much lower risk of getting into debt and it will help you stay on track with your financial goals or budget calendar.
Sinking fund vs emergency fund
On the surface, it sounds quite similar to an emergency fund, doesn’t it?
Well, the fundamental difference between these two forms is when you would use them.
Emergency funds are used only during extremely dire situations. It’s crucial protection because you will never know when there will be an emergency and you have absolutely zero control over how much it’s going to cost you. For example, car accidents or an urgent need for surgery.
Sinking funds, on the other hand, is an event where you can anticipate (most of the time) and plan for. The notion is to remove the element of surprise these events can cause to your savings buckets.
In short, think of your weekly/monthly budget as the first level, then the sinking funds as the second level (“money-to-blow”), and your emergency fund as the “absolutely-no-choice-left” level.
Sinking fund vs savings account
“Okay, what if I just use my savings account instead? Why do I have to go through the trouble of setting up a sinking fund?”
While mechanically, there isn’t much of a difference between a sinking fund and your savings account, the difference is mainly your desired outcome and easier budget planning. With a sinking fund, you have a specific target that you aim for (mostly short-term); with a savings account, however, it’s geared towards your financial goals (long-term goals).
A huge part of doing this also owes to the psychology of your spending. If you don’t set up a sinking fund, there is a good chance that you’ll exceed your initial budget, which then affects your overall financial planning.
Examples of sinking funds
There are no hard rules for what we can use sinking funds for. After all, we live in a world with a lot of needs and wants. But here are the six most common categories to help you get prepared:
- House sinking fund – Damage repairs, security systems, and maintenance. Anything that your insurance does not cover.
- Car sinking fund – Gas, insurance premiums, servicing, maintenance, or even saving up for a new purchase.
- Furniture sinking fund – New couch, new TV, new computers, new curtains, etc.
- Self-employment tax sinking fund – If you run your own business and are generating a profit, you need to expect the taxes. It applies to both freelancers and independent contractors.
- Wedding sinking fund – Whether it’s your own wedding or a friend’s, you’ll need to spend on gifts, transportation, and even to get a new suit or dress.
- Seasonal sinking fund – Chinese New Year, Hari Raya, Deepavali, or Christmas. There is bound to be some spending like giving Angpau, making traditional food, or wrapping gifts.
Sinking funds make your budgeting a little healthier as you’re allowed to spend on the most ridiculous items, as long as you plan for it. Just like other financial concepts and tools, it aims to reduce the uncertainty around your money.