Your car breaks down and needs some costly repairs. Your air conditioner stops working during a heat wave. Christmas is once again sneaking up on you and you just finished paying for last year’s gifts. Any of these situations may result in that sinking feeling when you have to pull out the credit card and take on debt (or possibly add to your debt) to pay for this new expense. But with sinking funds, you can save up for these infrequent costs and be ready for them whenever they pop up.
Sinking funds are like savings accounts, but you’re saving money that you know will be spent in the future. Sinking funds are not actually named for that sinking feeling, but rather it’s a term from the corporate world. When companies have to save money for a future expenditure, they often create a sinking fund to set aside additional money each month to pay for the upcoming cost when it comes due. It lessens the strain as the big cost can be saved up slowly.
In personal finances, sinking funds can be used for any expense – expected or unexpected – that can arise from time to time. While people typically create monthly budgets because most bills are monthly (mortgage or rent, childcare, internet and Netflix), there are many things that we have to account for that are not due as regularly. Whether it’s something you know is coming, such as the quarterly water bill or car insurance, or a big bill that is more surprising but still likely to happen, like a home or vehicle repair bill, a sinking fund can help you save up slowly for this eventual expense.
According to Mark Binder, chartered professional accountant, a sinking fund is a good idea for any expense that is going to cost you more money than what you could afford within your normal monthly cash flow.
“If you don’t set the money aside, your only other alternative is to incur debt,” says Binder, who typically sees clients using sinking funds for big experiences, like a wedding, child’s education or once-in-a-lifetime vacation. Retirement savings is also a form of sinking fund.
Sinking funds can keep expenses consistent each month and prevent unwanted surprises. They can also help you identify your true expenses. Understanding where all your money is going can ensure you truly appreciate how much you have for other things, like dining out. If you’re using cash at the drive-thru or for your daily caffeine kick, but then have to put your car insurance payment on an already strained credit card, you really can’t afford to be dining out as much. The trouble is, you may not see this until you understand where all the money goes and why you had to pull out the credit card in the first place.
Steps to establish sinking funds:
- Create a budget if you don’t already have one.
“If someone is going to be setting up a sinking fund, you really have to have a good handle on your monthly finances and that requires you to make a budget. You won’t know how much money you can put aside unless you go down and crunch those numbers and know how much money you do have,” says Binder. (For advice on creating a budget, read Developing a personal budget.)
- List your non-monthly expenses.
Examples include insurance, child’s lessons or sports fees, yearly subscriptions, car maintenance, pet care or personal wants and needs, like birthdays, Christmas and hair appointments (a cut and dye every few months can add up!).
- List your savings goals.
Examples here could be a vacation, home renovations, new car, wedding, your child’s education or retirement. You may also want to save for surprise expenses, like car or home repairs that don’t have a set price tag now but could hit you in the future.
- Once you have your list of expenses and goals, identify the costs of each and how long you have to save for them.
For example, a quarterly water bill for $200 will require about $66 a month to save before the bill comes due. If your or your child’s wedding is two years away and you want to save $15,000, you’ll need to put aside $625 a month.
For larger ticket items that don’t have a specific end date, such as a dream vacation, you can set a goal or simply save what you can. If you want to go on a cruise that will cost $5,000, you could plan to go in two years and save $200 per month. But if that’s too daunting, just put aside what you can afford each month. It’ll take you longer to get onboard, but you won’t be breaking the bank to get there. Plus, by creating a sinking fund before you go on vacation, you’re just making the monthly payments towards your vacation as you would pay off a credit card after a vacation – but this way you’re not paying interest! And that’s ultimately what sinking funds are about – not breaking the bank and making your expenses – all of them – accounted for and manageable, so you don’t wind up sinking into debt.
- Next, start saving!
Where to put your sinking fund
Where you set up your sinking fund depends on what it is going to be used for. For retirement or post-secondary education, there are specific funds (RRSPs and RESPs, respectively) to help you save. A financial advisor can get you set those up. But for everyday expenses and wish list items, a simple savings account or TFSA is more than sufficient.
Knowing yourself and how you handle money will also impact where to set it up, says Binder. If you think you’ll spend the money on something else, make the fund harder to get at by opening an account with a different bank than your main institution. Or use a TFSA, which can take a day or two to pull funds from, so you’re not as easily tempted.
You can also open multiple accounts for each fund or, if you’re comfortable with some basic tracking and accounting, save up for all your various expenses in one account and track it in a spreadsheet.
Binder advises setting up automatic payments to take the guesswork out of saving.
“The tendency for most people when they get their money, they tend to spend it. Having it automatically withdrawn makes it something that is out of your hands. Out of sight, out of mind. Then you realize, ‘Oh, I’ve got all this money here. That’s great.’”
Debt before savings
Binder urges anyone struggling under a mountain of credit card debt not to focus on sinking funds. While having a sinking fund can help prevent you from going into debt, you should not be worried about savings before you pay off current debt.
“If you have very high credit card debt, you may have to forget the annual vacation or curtail what you’re spending,” he says, specifying that long-term debt, such as a mortgage, is not a concern.
But once debt is paid off, setting up a monthly budget that includes sinking funds can help you maintain a debt-free lifestyle and give you more control over your finances.
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