We all have something special we'd like to buy for our home or in life. That old couch that has seen better days in your living room begging for a replacement or a vacation you thought about for a long time but keep pushing off because it is too costly. Paying for these significant expenses can be challenging, but a sinking fund may pave a better way.
Sinking funds can be a gamechanger for individuals and households. It is a valuable tool to add to your financial toolbox for savings. This strategy helps those who want to manage their finances better and gain peace of mind.
The timing for setting up sinking funds could not be better. Americans have been saving more, as illustrated by the US personal savings rate of 14.9% for May 2021. The unusually high rate due to pandemic-related spending constraints compares to 7.6% at the end of 2019. So why not make your savings work better for you? Setting up a sinking fund is easy to do and enhances your ability to save money for large purchases you will make in the future.
What Is A Sinking Fund?
Many bonds now have a sinking fund managed by a trustee who oversees the fund. Money is set aside periodically with a trustee for repayment of the portion of the principal. This action eliminates the need for a significant cash outlay for the company at maturity.
There is less risk of the company defaulting using the fund if it doesn't pay back the principal to bondholders. The fund adds protection and security for the bondholder that the company can pay off their debt. A sinking fund allows a company to raise capital with a lower interest rate to bond investors. As such, it improves a company's creditworthiness.
A Sinking Fund For Your Household
Once you determine what you want, say a new couch for $1,000-$1,500 for your living room, your sinking fund is for the sofa, not for another expense. You intend to save money to buy a couch, making monthly contributions to the “couch” sinking fund. Everyone has their budget, lifestyle, and timeframe for getting the couch or whatever it is you are targeting.
With a bit of planning, you can have what you need or want in your life without guilt. For example, if you have your heart on a particular $1,500 couch within a year (i.e., 12 months), your monthly savings goal is to contribute $125 to the sinking fund each month. Then, break the estimated spending amount into the monthly savings you plan to deposit into the respective savings account.
There is a greater temptation to pull out your credit cards for these large purchases without a fund. Your challenge is that you would have to pay your card balance in full or face a card balance growing on a compound basis at high interest rates. There are more benefits to setting up a sinking fund for purchases than the downside of adding to your debt.
Sinking Fund Vs. Emergency Fund
The sinking fund is for saving money for a known purpose you expect to purchase in the future. Typically, your sinking fund is for a specific planned amount. You know its timing and have been saving for it. The point of having a sinking fund is not to tap your emergency money or a general savings account.
Like you have loans for a house, car, and college, you are earmarking savings for larger items you want to purchase. Dollars are fungible and can go into a “car or house down payment” sinking fund. You can have a sinking fund by categories such as a house, car, vacations, Holidays, Christmas gifts, or charities. Alternatively, you can have sinking funds by being more specific:
- Kitchen remodeling
- Flat-screen TV
- Car maintenance and repairs
- Down payment for Car
- Down payment for House
- Pet bills
Labeling the sinking funds is a personal decision based on your household and its relevant savings goals.
How To Set Up Your Sinking Fund
1. Review Your Budget
When it comes to fixed costs, you have less flexibility to reduce amounts. But, on the other hand, discretionary spending varies based on money left over. You can learn more about different budgeting approaches here.
2. List Your Planned Purchases
There is no set number of sinking funds, though I would caution you about managing too many sinking funds. This process is about organizing your finances to make things more effective and efficient for you. As in the sinking bond for businesses, you are the trustee or manager of the funds.
3. Where Your Savings Will Go For Purchases
When you open a sinking fund for each type, your accounts differ from target amounts and timeframe. For example, when you are saving money for a house makeover or a down payment for buying a home, you probably are looking to build a five-figure money chest. If so, you can look for higher-yield savings or a money market account. On the other hand, for smaller purchases and shorter timeframes, avoid accounts that require minimums that penalize you with fees for not maintaining a specific balance. Essentially, you want safety and liquidity for the sinking funds.
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Use Sub-Savings Accounts
4. Need FDIC-insured Account
Whatever you decide to do, each sinking fund should be in an FDIC-insured savings account that is readily accessible. Then, for longer-term purchases, look for higher yields and minimize fees you may have to pay.
Benefits of A Sinking Fund
1. Better Budgeting
The better your budgeting, the better you can plan for your savings goals and spending. It is easier to save money when you have an intended target to set money aside for that purpose.
2. Conscious Spending
Taking the time and doing comparison shopping makes it less stressful and more enjoyable to anticipate the arrival of something new that you specifically want to get. You are not at that stage where salespeople will push you into an impulsive purchase you'll regret. Instead, you are more in control of your spending and more likely to negotiate where and when possible.
3. Delays Instant Gratification
With your sinking fund in place and growing closer to your spending goal, you can delay instant gratification. You have your mind not just on your expected purchase but on other things as well. Setting goals for one part of your life makes you more purposeful about your needs and wants. Achieving something on your list can be very fulfilling.
4. Avoids Adding Debt
Saving first, spending later, and avoiding debt where we can, can improve our creditworthiness.
5. Peace of Mind
1. Don't Have Too Many Sinking Funds
2. Sinking Funds Are Not Interchangeable
3. Keep Emergency Funds Separate
4. Don't Forget Savings For Other Goals
Over the longer term, these accounts grow faster than savings bank accounts, depending on your respective investments (i.e., stocks, bonds, real estate), and benefit from compounding growth.
This article originally appeared on Your Money Geek and has been republished with permission.
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” Spend less than you make, stay out of debt, and invest the rest”
The cents of money is about financial education, here to teach and inspire you about money, seek new ideas, and to create greater comfort in your world about one of life’s great stresses. Linda wants to use her financial skills honed by her professional experience to help others.