What Is A Sinking Fund? Why You Need One + How To Set It Up: A Complete Guide To Sinking Funds

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In the financial world, many people know what an emergency fund is; whether it's because they have one themselves, or can simply figure it out from the name. However, far fewer people have heard of or utilize a sinking fund intentionally. Truthfully, a sinking fund is something we should all have. It saves our emergency fund for real emergencies and gives us the opportunity to enjoy our money guilt free! Sounds pretty amazing right? Today, I'll walk you through what exactly a sinking fund is, how it differs from an emergency fund, why it's important, and some tips for setting your sinking fund up!

[RELATED] A Complete Guide To Your Emergency Fund [What, Why, How Much, + Where To Park It?]

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A sinking fund is a way for you to save money every month for something you know is coming. For instance, every year we know the holidays will inevitably be upon us and we'll need money set aside for holiday gifts, decor, and festivities. Another common example (which I'm currently experiencing), applies to homeowners who know that their roof or appliances have an expiration on them. Meaning you have to replace them after a certain amount of years usually.

Why is it called a sinking fund?

When I first heard the phrase “sinking fund,” I totally ignored it. If conjured an image of a sinking ship and there was no way I wanted to be on that boat! Until I did more research. You see, the phrase “sinking” actually has to do with debt repayment and the fact that, with regular payments, you are decreasing the level of debt (a ship you'd actually want to sink and never go back on!).

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Over the years, the idea of “sinking” has morphed from debt focused to savings focused. In fact, many of you have probably created a sinking fund in the past without realizing it. If you've ever set aside money to buy something you wanted then you've done it!

A sinking fund allows you to plan and save for a specific expense that you know is coming up. An emergency fund is there in case of an emergency. For instance, roof's typically need replacement every 30 years. We are setting aside money into a sinking fund for this. However, say a big hurricane hits and your roof needs an unexpected minor repair after only 10 years, you'd dip into your emergency fund for this.

Here's a pretty common list of ideas for sinking fund categories:

Holidays (Read ways to save on Christmas, Thanksgiving, and Halloween!)
Annual subscriptions
Doctor's visits:Medical premiums, copays, dental appointments, braces, eye exams, glasses, etc.)
Birthdays
Home updates/replacements with a historical expiration date (think replacing your washer/dryer, roof and other appliances etc.)
Back-to-school (tuition clothes, classes, books, after school activities, teacher appreciation)
Vacations (summer break, spring break, winter break, other travel)
Insurances
Vehicle maintenance & repairs
Activities
Gifts
New Car
Taxes
Pet check ups
Seasonal clothing (uniforms/work clothes)

Lexington Law also shared some ideas for savings goal by decade (like top goals for your 20s, 30s, 40s, etc.). Read it here!

Why is a sinking fund important?

Some people may be reading this right now like, “great, but I had no idea that my roof was going to need to be replaced after 30 years! Not common knowledge to me!” That's totally okay! The entire reason a sinking fund is important is to reduce financial stress and anxiety.

If you didn't know that many home appliances and things have a typical life span, that's okay. You can still find peace of mind in a sinking fund because it gives you permission to have fun with your money too! Scroll back up and check out that list of sinking fund ideas I shared… you'll notice, most of the things on that list are enjoyable! Meaning you can take that vacation guilt free! It just so happens that my current sinking fund focus while writing this post is on #adulting responsibilities (re: repairing my roof).

Plus, a sinking fund gives you a buffer so that you don't need to swipe your credit card when you don't have the money. It protects you from destroying your credit score and financial position. Granted, sometimes our credit scores take a nosedive due to things outside of our control, like identity theft. In those instances, Lexington Law is here to help. Contact them for your free credit repair consultation here. Clients also receive identity theft insurance up to $1 million, credit coaching and score improvement analysis, an inquiry assist tool to challenge hard inquiries on their reports, and online/mobile support.

I'm going to share two approaches for setting up your sinking fund:

First approach to setting up your sinking fund:

To create your sinking fund to determine how much you'll ultimately need to reach your savings goal. Next, divide that number by how many months you have until you'll need the money. This will give you the dollar amount to set aside each month in your budget towards your sinking fund.

Specific example of this sinking fund savings approach for this year:

Every year you know the holidays are coming. Historically, you've spent $500 on them. So this January you decide to get ahead and do $500 divided by 11 months and determine that starting in January you'd need to put aside $45.45 to start your holiday shopping in November. Feel free to round up for even numbers.

Slightly variable example for a longer term example:

You need $10,000 for a new roof and your estimating you'll need it in 15 years. Keep in mind, your roof could go a little earlier than 30 years, and it could cost a little more than $10,000 since we are talking about a time in the somewhat distant future (re: inflation).

You take the total dollar amount you'll need ($10,000) divided by the number of months until it's due (to convert from years to months you'll do: 15 times 12 = 180). So $10,000 divided by 180 is $55.55. Each month, you'd want to save at least $55.55 into your sinking fund.

Now personally, I'd probably round that up to $60 a month and put that money in a high yield savings account or a CD for 5 or 10 years so that you're earning a little more interest on the money and it acts as a better buffer towards inflation (though it likely won't keep up with inflation entirely).

Lexington Law agrees with this type of savings approach, and share a few more tips in this post. If you chose a CD, just don't lock it away for more than 10 years, if you're projecting needing it in 15. You want to give yourself some buffer room incase you need to pull it out a little early.

Another approach to creating your sinking fund:

Maybe you are like, “okay great Rachel, but I don't want to think about things that are 15 years out and I'm not that organized to look ahead and remember all the annual things I should be planning for. And if I just write a list of all the things I'm trying to save for, I'd end up with a number higher than what I even bring home each month!”

That totally cool, there's another way we can approach the sinking fund that may feel less overwhelming since it works off budgeting only one number to start. For this other approach, you'll start by looking at how much money you have to put towards saving every month. If you already know this number of the top of your head, great!

However, if you need help calculating this number this paragraph is for you:

So if you remember my beloved 50/20/30 guideline (super simple 3 number budget); you know that the “20” stands for “financial goals.” Meaning 20% of your take home pay should be allocated towards financial goals. Once you have your emergency fund where you want it to be, and your revolving debt taken care of, you can use this entire number towards a sinking fund. So let's say you bring home $37,000 a year, that would be $3,083 per month. Twenty percent of $3,083 is $616.

Example using this approach with just one number:

So each month, you have $616 to put towards your sinking funds. Next write a list of the top priorities for your sinking fund:

Retirement
Vacation
Prepping for home upgrades
Gifts (holidays and birthdays)
Annual subscriptions (Amazon Prime)

Now you can focus in on just one of those numbers at a time. So maybe you know that Amazon Prime is $119 so you set aside $10 a month. That still leaves you with $606. From there, you can just use a ratio that looks right for your situation.

Based on my personal lifestyle it'd could like this each month:

$230 for retirement
$100 for a vacation
$200 for home/tech upgrades
$75 for gifts
$10 for annual subscription

At the end of the year, my sinking funds in this example would look like this:

$2760 for retirement
$1200 for a vacation
$2400 for home/tech upgrades
$900 for gifts
$120 for annual subscription

Now you can do something you want (vacation), without feeling guilty. You can navigate the holidays and gifts without stress. Retirement is still being planned for (ideally you'd max out your retirement contributions, but something is still better than nothing!). And you can even handle some unexpected home/tech repairs or upgrades without touching your emergency fund. Again, you'd break this down in whatever way makes sense for your financial situation.

Is this really going to work?

Of course, being able to save any money is a privilege. But when every dollar is accounted for in our budget, we become far less likely to overspend. Imagine if you left the $616 just floating around your account. I bet you'd be far more likely to splurge on coffee's, random clothes, and the like. With a sinking fund, you're far less likely to overspend, and this is coming from a recovering overspender!

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Now, if you're feeling overwhelmed, let's simplify:

I love simplicity. Personally, the fewer the better in my opinion. You could take that example and break it into four areas:

Long term goals: These are things like retirement, planned upgrades or vacation that will take over a year, and the like.
Moderate to large planned annual expenses: Things like a vacation for that year and a round up of holidays/birthdays.
An “oops” fund for forgotten annual expenses: Things that you know you'll need to do each year, but often feel like “oops” I forgot until they come up in your budget. Think annual subscriptions and clothes for kids (they really do grow so fast!!), bi-annual trips to the dentist, etc.
The Unexpected (optional): This sinking fund it totally up to you. In the example above, you'll see I created a fund for home and technology upgrades/replacements above. You can use that money for unexpected repairs too so you don't have to touch your emergency fund. Totally up to you!

Here's my rationale for adding home/tech repairs/upgrades/replacements as a sinking fund:

My husband and I are both entrepreneurs and new homeowners. Both of those things mean we have a lot of unexpected things in our lives. We try to leave our emergency fund (with 1 years with of expenses) untouched in case we both aren't bringing in an income for whatever reason. If a computer breaks, we need to get it fixed asap as part of our businesses.

Also, the house we bought is kind of old and needs some work done. Thus we have more unexpected home expenses than someone who bought a new construction house. For us, having this type of unexpected sinking fund gives us an additional buffer we need so that we can really leave our emergency fund for emergencies.

And there you have it! My complete guide to sinking funds!

What do you think? Have you unexpectedly been using sinking funds? Are you going to try it out? Remember, even if you start small and just focus on a sinking fund for holiday expenses this year, that's an excellent first step! It's okay to walk before we run, especially when it comes to our finances!

The biggest takeaway I hope you have from this post: One small choice a month can make a huge difference by the end of the year!

And don't forget, if you think there are inaccurate or unfair negative items on your credit profile, contact Lexington Law today!