What is a Sinking Fund?
12 Jul, 2020
I realised recently that I rattle off financial terms, assuming that people know what they are. And that annoyed me a bit, because the reason I started blogging was to demystify financial jargon and yet, here I was, rattling off a bit of jargon!
One of these terms is ‘sinking fund’.
Today I thought I would quickly explain what a sinking fund is and why I use them myself.
What is a Sinking Fund?
A sinking fund is just a bank account that I create for a specific purpose. I create a sinking fund when I know I have a large expense coming up that I know the exact value of, it is a fixed amount. I also use them when I’m ‘saving towards’ something, that I may not know the actual dollar value of.
For example:
Annual car insurance - $800
New laptop - $1,800
Dental work - $8,000
Holiday - saving towards
Vet Bills - saving towards
A sinking fund lets me break down an expense into smaller parts, so I can set money aside weekly into a separate bank account. Put simply, they make it easier for me to budget as it tidily sets money aside out of the way and that means I’m unlikely to spend it.
Take our annual car insurance invoice of $800. I broke $800 down into 52 weekly payments of $15.38. Now, every single week I have an automatic transfer of $16.00 into my ‘car insurance’ bank account, so by the time my insurance rolls around for payment again (where I will pay it in one lump sum to get the discount), I will have the full amount available. No stress! I can easily afford $16 a week. It takes the pressure off having to pay such a large invoice of $800 in one go.
Another sinking fund I have set up is for dental work for my daughter who needs braces. Dental work is freaking EXPENSIVE in New Zealand and paying for this needs some planning if I don’t want to put a strain on my budget or take on debt. But because we realised early on that our daughter’s teeth were very wonky we actually took her to a dentist a couple of years ago and asked her opinion. She agreed that it was likely that in the future braces would be needed and the approximate costs would be about $8,000. So, ever since then I have been transferring $40 each week into a separate bank account so I could build this up. If some unexpected money came our way (like from a tax return), this is where I put it so I could build this account up more quickly. We finally have (almost) enough money put aside so have recently started the process of getting braces fitted by her orthodontist. I asked them for a current indication of costs (it’s still about $8,000) and I’m now happy that we can cover each invoice as it comes in. I say that we have ‘almost’ enough because dental work is a long process so with continuing payments into that account it will continue to build and we will always have the cash to pay on time. I continue to ‘save towards’ dental work.
Now, I know that others may think that they could get the work done and then pay the orthodontist back in weekly instalments, but to me, that is creating debt and I don’t want to do it that way. For something like dental work, we knew years ago that it was going to be a possibility, so for us, it was the right thing to do to plan ahead for it.
How many sinking funds?
Currently, I have six sinking funds slowly building up:
Vet bills - $10 pw (per week)
A new laptop for our daughter for High School in 2021 - $30 pw
Tax - the amount varies
Holiday - $100 pw (I know right, priorities!)
Dental Work - $40 pw
Car Insurance - $16 pw
I have also just been made aware of the cost of school uniforms for 2021, so that is yet another sinking fund I’ll have to set up shortly! I tell you, my child who has previously been pretty cheap to run has now become EXPENSIVE to maintain and I’ve calculated that 20% of our income this year is being spent on these expenses. Crikey. As an aside, we talk to her about these costs, so she has actually started her own sinking fund to save up and put some money towards her own laptop. This is teaching her the skill of predicting upcoming costs and preparing for them.
Some of these sinking funds are open-ended and we just keep transferring into them, like the Vet Bills fund, but others, like the laptop fund, have an end date. For that one, we have priced up a laptop, divided that amount by the number of weeks we have remaining until we have to purchase it and that is the amount that we transfer into that particular account each week. If we have some unexpected cash come in, I just transfer it into these accounts and it helps me reach my goal faster. Once I reach the goal amount OR the purchase has been made, I’ll divert this payment somewhere else.
Less Stress
Now, instead of worrying about how we might pay for a big upcoming expense, I just have peace of mind that we have it under control. And I’m sure that the orthodontist will feel the same when I pay on invoice! There will ALWAYS be something vying for your hard-earned money and if you don’t set some of it to one side in a sinking fund and give it a name, like “laptop”, then I can guarantee you that your dollars will easily be gobbled up elsewhere.
You may feel like you can’t spare $40 a week to set aside for a $1,000 bill that you know you have coming up, but just ask yourself, if you can’t find that money today and you don’t start a sinking fund today, how are you going to find the total amount required to pay when it is actually due? What is your plan exactly? A credit card? Afterpay? Extending the mortgage? Borrowing from family?
One thing I have noticed over the years is that many dismiss a sinking fund because:
They think they don’t need to budget
It takes too long to meet the goal
They know they will just raid the account and spend the money elsewhere
BUT they may start a simple savings account for their child and deposit $10 a week into it. They know they can’t touch this money, they don’t view it as theirs anymore, it’s for their child. Then lo and behold, that money starts to grow and before they know it 52 weeks have passed by and the balance is $520. This is an ‘ah-ha’ moment for many and they will then realise the power of steady saving, planning ahead and discipline and start to apply it to their own bank accounts too.
Start a Sinking Fund today
Money does not magically appear, but if you start a sinking fund today, it kinda does, because it just quietly builds up when you are not paying attention and when that due date arrives, it’s just a simple transaction to pay it, no stress, no anxiety, just a calm feeling of knowing you had planned for it and achieved it.
There you have it, SINKING FUNDS are a really powerful budgeting tool and most people I know who achieve financial success are using them.
