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What is a Sinking Fund? How to Use It as Part of Your Budget

Just about everyone is familiar with the key concept of a budget.

If it’s set up properly, it will enable you to allocate extra funds into savings or debt payoff on a monthly basis.

But there’s another strategy that should be added to most budgets, referred to as a sinking fund.

Unless you’re an accountant, you may not be familiar with the concept.

But it’s a way of adjusting your budget to accommodate predictable, but irregular expenses, or even to fund very specific savings goals.

Sinking Funds: An Established Practice in Businesses

Sinking funds are well known to large, publicly traded companies.

In the business world, they’re funds set up to eventually pay off debts or bond issues.

For example, let’s say a publicly-traded company issues a 20-year bond for $100 million. During the entire term of the bond issue, the only payments they make to the bondholders will be interest payments. Principal will be fully due when the bonds mature.

But rather than making principal payments directly to bondholders, similar to monthly mortgage payments, the company arranges to have those payments put into a sinking fund.

Under ideal circumstances, there’s sufficient money in the sinking fund to retire the bonds at the end of 20 years when they mature.

It will even give the company an opportunity to earn interest income on the money in the sinking fund, which will at least partially offset the interest they’re paying the bondholders.

A sinking fund may be used by a business for purposes other than retiring debt.

For example, it may use of funds to repurchase stock, or even to accumulate capital for expansion, like the purchase of plant and equipment.

While the whole concept of a sinking fund is primarily for large corporate finance, it can have a valuable purpose under at the personal financial level as well.

The Sinking Fund Concept in Your Personal Finances

If you have a budget in place, you’re well aware of the fact that there are recurring monthly expenses.

But there are also irregular expenses, like insurance premiums that may be due on a quarterly or semiannual basis.

You may also have a vacation in the coming year that you’ll want to fund in advance.

Either of these anticipated expenses can be covered using a sinking fund.

It’s even possible to set up a sinking fund for contingent expenses.

A good example is car repairs and maintenance. If you estimate that will cost $1,500 over the course of a full year, you can allocate $125 per month out of your budget to that expense. And when a repair or maintenance expense does hit, you’ll already have the funds set aside for it.

The basic idea of a sinking fund is to smooth out the cash flow in your budget.

Sure:

There are regular monthly expenses that fit easily within a budget.

But you can use a sinking fund to effortlessly cover those budget-busting expenses, that while thoroughly predictable, can throw your budget out of balance.

Sinking Fund vs. Emergency Fund

A sinking fund is not to be confused with an emergency fund.

Each has a completely different purpose, and you should have both in your financial portfolio.

The fundamental difference between the two accounts is expectancy.

An emergency fund is an account you set aside to prepare for the unexpected.

That can be something like a large medical expense, a major auto repair, or an unexpected but necessary out-of-town trip, perhaps to help an ailing family member.

By contrast, a sinking fund is an account you set up in anticipation of a major expense.

For example, let’s say you plan to purchase a new car in one year. You can begin moving funds into the sinking fund on a monthly basis that will cover the down payment on the new car one year from now.

This can be done with any major, expected expense.

The Ultimate Purpose of a Sinking Fund

The sad reality is that many people pay for expected major expenses using credit.

But when you borrow money to pay for a major expense, you’re actually not paying for it – you're financing it.

Not only does that require adding a new monthly payment to your budget, but you’ll also pay interest on the loan.

Avoid debt

By using a sinking fund to pay for major, expected expenses, you’ll be paying for those purchases in advance.

There will be no monthly payment to a creditor and no interest expense.

In fact, quite the opposite, your sinking fund will give you an opportunity to earn interest on your money while you’re building up your account.

Reduced to its most basic level, a sinking fund is a tool you can use to stay out of debt. Instead of paying for your purchases after the fact, you’ll be paying for them in advance.

Less stress

There’s another unanticipated advantage and that’s the elimination of stress.

There’s no question:

Monthly debt payments are one of the biggest stress factors in human existence.

You can use the sinking fund concept to move out of debtor status.

Absent those debts, and the monthly payments that come with them, your stress level will go way down.

That will enable you to pay for the things you need and want, but without the extra stress that debt generates.

How to Create a Sinking Fund

You probably have a number of expenses that would benefit from a sinking fund.

Start making a list of those expenses.

Examples of expenses that could be included in a sinking fund are:

  • Annual, semiannual, or quarterly recurring expenses
  • Short-term savings goals, like a vacation or the down payment on a car
  • Known variable expenses, like repairs and maintenance for your home and car
  • Out-of-pocket medical expenses

One of the best ways to do this:

Tally up all your anticipated irregular expenses and spending goals on an annual basis.

You can open a single bank account with the goal of fully funding all expenses over the course of one year. You can then take funds out of the account for each expense or goal as it arises.

Alternatively:

You can set up a general sinking fund for smaller expenses and goals, and one or two accounts for particularly large ones.

For out-of-pocket medical expenses, a good option will be to set up a health savings account (HSA). Not only will that enable you to accumulate savings to cover your copayments and deductibles, but your contributions to the plan are tax-deductible.

Probably the best way to fund your sinking fund will be through automatic payroll deductions.

That will fold the contributions to the account into your regular budget, eliminating the need to come up with periodic lump sums for the account.

How Big Does a Sinking Fund Need to Be?

We just describe how you can determine the size of your sinking fund by adding up all your anticipated irregular expenses and short-term goals.

Optimally, you’ll want to have enough money in the sinking fund to cover all those expenses.

But naturally, the size of the fund will also be dictated by any budget constraints you have.

For example, you may only be able to partially fund the account out of payroll contributions. But you may also be able to make large lump sum contributions by directing your income tax refund or any bonus income into the account.

Where You Should Keep Your Sinking Fund

In the financial scheme of things, sinking funds sit somewhere between emergency funds and retirement accounts.

That is:

While you typically have no immediate use for the funds, you’ll be drawing on them long before retirement.

That will generally limit your options to safe, interest-bearing investments.

After all, if you expect to draw most or all of the funds out of your sinking fund within the next 12 months, you certainly won’t want to invest the money in mutual funds or stocks, which could decline in value.

The best options are with high-yield savings banks. You can hold the account in a high interest savings account, money market account, or even short-term CDs.

High-yield online banks work particularly well for this purpose. The money is available when you need it, but it’s not as close as your local bank, which may encourage frequent raids through the ATM machine.

You can earn high yields on your sinking fund at the following online banks:

Final Thoughts

If you’re looking to avoid debt, reduce stress, and still be ready for those irregular expenses or savings goals, setting up one or more sinking funds is the perfect way to cover all those points.

It will also offer you an opportunity to build these expenses into your regular budget.

That will avoid the need to come up with a large amount of money at what could prove to be an inconvenient time, as well as to avoid going into debt.

The sinking fund itself can simply become another line item in your budget, allowing you to be fully prepared for all financial contingencies, regardless of when they occur.

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