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What Is A Sinking Fund?

what is a sinking fund

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I’ll be honest with you. I didn’t know what a sinking fund was until last year. The term sinking fund was something I’d never heard of before and I talk about saving money every day. The shame. But like anything in life, we don’t know, what we don’t know and every day is an opportunity to learn something new. So if sinking funds are an unknown to you, don’t stress. This article will tell you everything you need to know….and a little more.

Sinking funds are savings pots for larger planned expenses. Like many of us, you might be planning a foreign holiday, a new car purchase or even preparing for an upcoming event such as a wedding. The question “Where to put your savings?” is usually answered by a sinking fund. They allow you to save money in cash so that you don’t go into debt to pay for the event or activity.

So if that sounds good and you’re planning to save for a medium-term goal or purchase, then let’s discuss sinking funds a little bit more to help you with your savings goals.

And before we go any further in the article. There’s rarely a reason not to save money in your sinking funds. They are almost always a great idea!

What is a sinking fund?

Sinking funds are planned savings pots that are used to pay for upcoming purchases. While there is no strict saving schedule in a sinking fund, you may wish to contribute to them regularly. The savings are earmarked for specific events, activities or purchases.

Let’s dive into that further. Say for example you are due to get married in 4 years. Congrats by the way. By setting up a “Wedding Sinking Fund”, any money you save into that savings account is destined to be spent on your wedding. Many people regularly contribute to their sinking funds with every wage packet, however, there are no set rules and you can add money any time you have additional funds to do so.

By saving over an extended period and in advance of the need to use the money, you are more likely to have the funds available in cash to make the purchase or to pay for the event and therefore the chances of going into debt are much less. And if you have ever listened to me talk about debt before, generally we want to avoid debt as much as possible.

Sinking funds aren’t solely for use on huge events or life circumstances. They can be used for almost any planned expense. Below are a few of the sinking funds I save into.

  • Golf Fees
  • Car maintenance and other costs
  • Holidays and other travel costs
  • Gifts
  • New home deposit

I will admit, that many of these costs could be covered in a monthly budget without a sinking fund. However, I and many like me find that spreading the cost of planned purchases across the year gives more freedom in our monthly budgets. 

Imagine an unexpected car maintenance came around just as you booked your holidays. This could put you into debt unexpectedly. A sinking fund takes the risk of this away.

You can create a sinking fund for any planned financial goal. But it’s mindful to note that an emergency fund should be filled first.

Sinking fund versus emergency funds

While both sinking funds and emergency funds are savings pots, they should be treated and considered very differently. 

Sinking funds are for planned expenses whereas emergency funds are for those unplanned expenses we all inevitably face. These emergencies could include a broken-down car, a new fridge or even a replacement boiler. The important thing is that these are unexpected expenses. But as we all know, unexpected things happen all the time.

Emergency funds stop us needing to go into debt to pay for the emergency. And this is incredibly important. Because debt is costly! It costs us money now and it continues to cost us over the length of the repayment. Furthermore, debt stops us from building wealth over the long term. Being in and paying off debt is one of the most stressful things a person can do and if you are in debt, definitely check out my debt repayment series.

The argument I hear is that debt is normal and I promise you, it’s not. It has been normalised yes, but being in debt is one of the worst financial decisions anyone can make. Avoid it at all costs.

Remember, sinking funds are for planned expenses and emergency funds protect you from those unexpected ones.

It’s also important that you keep your emergency fund for true emergencies. This is not your “I fancy a holiday fund” or the “Oh mummy I love that handbag fund”. Treat this with caution and only use the money in this fund for true emergencies, because they will inevitably happen.

Sinking fund vs. savings accounts

One of the most common misconceptions is that sinking funds and savings accounts are the same thing. And it is easy to see why. A sinking fund is how you save your money for planned expenses. A savings account is normally where you put the money.

Imagine you are saving for several upcoming expenses. This could be a wedding, a holiday and possibly a car purchase. Now you also have a household budget to maintain each month. When using your savings account, this generally shows your entire savings balance. The lines get blurred and the balances are mixed. Even I find this difficult to manage because when the money is all mixed in one account, it’s easy to spend.

Setting up multiple sinking funds correlated to your goals helps you to split your savings account into the appropriate funds. And I find this incredibly easy with Monzo’s Savings Pots.

Monzo pots

If you’re a Monzo customer, this process is incredibly straightforward with their “Pots” feature. With just a few clicks, you can create a new pot and this instantly becomes a sinking fund. 

What’s particularly handy as well is that with the Monzo salary sorter, you can automatically transfer money into your sinking funds with every new salary received. 

In my opinion, there is a significant drawback to using Monzo pots and I have reached out to Monzo about this. Currently, the pots are part of the regular current account which does not attract the 4% interest rate that Monzo offers on its instant access savings accounts. To get the 4% interest, you have to lump all your savings together. Which as I mentioned before defeats the purpose of the sinking fund strategy.

To keep a record of this, I transfer the funds to the pots first and then into the savings account. I do also have a spreadsheet with the sinking fund balances. All bases covered!

Benefits of sinking funds

No matter what your financial situation is, everyone can benefit from sinking funds. Sinking funds are a great way to budget and plan for expenses that we know happen each year. 

Using your sinking fund for planned expenses such as holidays or planned maintenance to your home and car, ensures you don’t need to use your credit card or go into debt to pay for them.

Sinking funds are beneficial for several reasons:

  • They help people plan for significant life events such as weddings or buying a home.
  • You can use the money saved instead of going into debt.
  • Prepare and plan for life costs that inevitably happen such as changing cars or tyres.
  • They help you plan for upcoming purchases and give you ample chance to stop the purchase before it costs you money or you get buyer’s remorse.

Challenges of using sinking funds

Creating a sinking fund is not without challenges. Firstly you must have enough additional income in your budget to fund these savings pots. In the current climate many households are struggling with their budget and without the headroom to make any savings, putting money into a sinking fund might not be possible.

Sinking funds much like emergency funds also require significant discipline to manage. Many people I speak to have trouble not spending their savings. And I understand that. Earning money is hard and saving money is harder. Why shouldn’t you spend your hard-earned cash? Well, you’ve set up your sinking funds for very specific reasons and I promise that almost always, these reasons are greater than that impulse purchase.

Anyone who is embarking on a financial journey, whether that’s saving or investing for their financial goals should understand the concept of delayed gratification.

How to set up a sinking fund

Look, sinking funds are great and there’s little negative that can happen by saving money. If you haven’t set up a sinking fund before, here’s how to do it.

  1. Decide what you are saving for in this sinking fund
    It could be the deposit for a house or it could be your annual golf fees. The main thing is that this is a known expense that is going to happen in the future. If you plan and budget for it now, it won’t be an issue that costs you more money when it needs to be paid.
  2. Choose where you’ll save your sinking funds
    If you bank with one of the digital banks such as Monzo or Starling there is the ability to set up savings “pots” or “places”. While these pots look like they are separate from the main current account, they are just segments of the main account. Within your chosen account, set up a new savings pot and name it so that it is easily identifiable.
  3. Decide how much you want to save
    When setting up your sinking fund in MONZO, you also can set the target amount to be saved. This serves to be a significant motivator as the balance increases and you get closer to the total saving amount. A top tip is to use the roundup feature to add money to this account with every purchase you make. By setting your target sinking fund balance amount, you can then calculate how much you need to save each month or year to achieve your goal. For example, if you want to save £1000 for a new car deposit 12 months from now, you would need to contribute around £83 a month to meet this goal.
  4. Set your monthly budget to contribute to your sinking fund
    Budgeting isn’t fun and saving money is hard. But unless you plan to contribute to your sinking fund and set your budget to afford this, you might not ever achieve your sinking fund goals. Using our example above, you would need to assign £83 a month to your sinking fund. If you currently meet or exceed your budget each month, you might need to reduce spending elsewhere to make the headroom you need to save. Setting a budget is the cornerstone of any financial plan. It is forward-looking and will help you to increase the amount you can save from your income. The more you save, the quicker you will achieve your financial goals. 

And with that, you’ve created an incredibly robust sinking fund plan in just four easy steps. But you’re probably thinking about all your upcoming expenses and asking yourself when you stop creating sinking funds. I know this because that’s what I did.

How many sinking funds should you set up?

Remember you can afford anything, but you can’t afford everything and having too many sinking funds might slow you down in achieving any of them. Simplicity is the key to success and rather than having a sinking fund for every potential purchase, it’s often better to group these.

Rather than having a new kitchen fund, a bathroom fund and or a garage conversion fund. A simple “Home” fund keeps things simple but would allow you to prioritise the spending as you see fit.

The other side of this is that our budgets are not infinite and there is only so much money you can save towards your sinking funds each month. Prioritising your saving is key and this does require significant consideration of your financial goals. There is no right or wrong answer. Only what is right for you.

The main thing is that you track your progress and see the results of saving. Your goals may change during the time it takes you to save money, and that’s ok. It’s your money and you can put it to use as you wish.

Sinking fund round up

Saving little and often can become so much greater with planning and discipline. Staying out of debt is one of the core features of building wealth and sinking funds if used alongside emergency funds can completely mitigate this entirely.

Remember it’s not normal to go into debt and the further you can stay away from it, the richest you will eventually become.

If you like my written content, you’ll love the video versions of all my articles. You can find them over on the Foundered Money Youtube Channel.

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