Saving for a rainy day is great, but saving towards a goal? That feels even better. As you get closer to your goal amount, your sense of satisfaction increases. And if you’re saving towards buying something, then you’ll appreciate your purchase even more, as you’ve built up anticipation towards it. You should note that when you’re saving for a fixed expense in the future, it’s not simply ‘saving’, it’s called creating a ‘sinking fund’.
What is a sinking fund?
While the name sounds ominous, a sinking fund is a wonderful thing to have. A sinking fund, in simple terms, is money set aside for a very specific expense that you expect to incur in the future. One main characteristic of a sinking fund is it’s usually a big enough amount that it would greatly affect your budget or savings if you had to pay for it out of pocket. Another aspect of a sinking fund is that you use the money for its intended purpose alone and do not (or at least try not to) dip into this fund for any other expense.
How is a sinking fund different from savings?
We’ve already mentioned that sinking funds are not the same as savings. Let’s take a closer look at the exact differences between a sinking fund and regular savings:
Sinking funds are savings with a specific goal
When you create a sinking fund, you do so with a particular expense or goal in mind. It could be a holiday, a down payment on your new house, or a specific purchase such as electronics. It can even be funds you want to keep in place for expenses you know will occur but aren’t sure when — such as car repairs or home maintenance. The idea is that you will use the amount saved for that goal and not for any other purpose. For example, if you have a sinking fund to buy a new car, you should not dip into it any time you need extra funds for something else such as going shopping or home renovations. Of course, it is up to you to be strict with yourself and put the right boundaries in place.
One way to keep the temptation of dipping into your sinking fund at bay is by investing in a GIC. Your initial deposit is $1,000 or more and you choose the term length of your investment. You can withdraw the funds only after the term ends. Trying to withdraw your funds before the term period ends will lead to a penalty, serving as an extra barrier to using your sinking fund for any other purpose.
Advantages of sinking funds
Doesn’t a sinking fund sound great? Now, let’s look at some of its key advantages:
Sinking funds do not need to be replenished
When your savings are spent, simply make sure to start saving up again so that you have some funds on hand in case of emergencies or any other expenses. However, once you spend the money in your sinking fund (for the reason it was intended, of course), you don’t have to worry about building it up again. Sinking funds complete their purpose once the expense they were designed to save for is met. Once that fixed expense has been taken care of, the goal of your sinking fund can shift toward the next expense you have in mind. Or you can simply choose to close your sinking fund. In this way, sinking funds can help you to save selectively and don’t need to be a permanent part of your budget.
Sinking funds help you protect your budget
Speaking of your budget, did you know sinking funds are the perfect way to protect your budget? Sinking funds are usually created for a large expense that you can expect. If that expense had to be borne out of the blue, you would have to take money out of your existing savings, shuffle around your budget to cut expenses, and maybe even take on debt. But if you already know that you will have a specific expense, a sinking fund can protect your budget. A sinking fund does this by allowing you to set aside money in a planned and systematic way. Take for example, if you have a sinking fund for a big anniversary or birthday party. You can put money aside every week or month. When the time for your party rolls around, you can use the money from your sinking fund without worrying about messing with your budget or suddenly having to spring for all the expenses such as venue, food, drinks, decor, gifts, etc. You’ll already have the funds you need and can protect your budget from any unwanted dents.
Sinking funds allow you to diversify your savings
Putting all your eggs in one basket is never a good idea. This stands true for life as well as for your finances. Of course, we don’t mean that your savings aren’t ‘safe’, rather that it’s good to have different types of savings. One kind of savings is the good old emergency fund. This should amount to about three to six months of your living expenses. Next you may also have a general type of savings, money you put aside over and above your emergency funds. This type of general savings can happen when you have a strong saving habit or come into some money and would like to keep it handy for any incidental (but non-urgent) expenses. Yet another type is a sinking fund, that involves money set aside for a specific purpose. While an emergency fund is essential, and general savings are good to have, the thrill of a sinking fund is something else. As you see your fund grow, it instils confidence in yourself. It makes saving interesting and something to be enthusiastic about, rather than a burden.
Now that you know about some of the advantages of a sinking fund, let’s examine some key considerations you need to make while setting up a sinking fund of your very own.
What should I consider when setting up a sinking fund?
Here is a series of questions that will help with your considerations. Once you have the answers, you’ll have everything you need to set up your own sinking fund.
What do you want to save for?
A sinking fund depends on what your large, fixed expense will be, so your first step is to decide what exactly you want to save for. There are plenty of options:
- specific childcare expenses,
- medical expenses,
- taxes,
- vacations,
- home repairs or renovations,
- buying a car,
- car maintenance,
- gifts, or
- charity.
Once you decide your purpose, you’ll be better equipped to answer question two.
How much do you want to save?
With a purpose in mind, you can calculate or estimate how much you would like to save. For cases such as charity or home renovations, you can choose to put aside as much as you want while taxes on your interest earnings would be capped by a limit depending on your income. Either way, you should decide on a figure, even if it’s the minimum you absolutely must save.
How long do you have? Or how long do you want to save for?
While knowing your goals (both purpose and amount) is a great start, the next thing you need to figure out is the timeline for your sinking fund. If it is a fixed expense bound by time such as a birthday, you will have a limited amount of time to save. On the other hand, if it’s a fixed expense that could happen only once you need the funds, then you get to choose how much time you must build your sinking fund. You can go easy on yourself and spread it out over a longer period or focus on building your fund as quickly as possible.
How will you save?
Got your goals and timeline in place? Now you need to think about how you can make it possible in your existing budget. Or you can make a new budget taking your sinking fund into consideration. Make sure to allow for enough money to be put in your sinking fund and plan your expenses and debt repayment such that you won’t be prevented from adding money to your sinking fund.
Where will you save?
Lastly, you need to decide where your sinking fund will be saved. Will it be in your deposit account or a high-yields saving account? Should you get a term deposit or something else? Consider all your options before deciding. You want to make sure you can earn some interest on your sinking fund savings while also avoiding paying any bank fees.
Once you have all your answers, you’re well on your way to setting up your sinking fund. Need help along the way, or just financial help in general? Contact our financial experts today!