Understanding the Essentials of a Sinking Fund: What You Should Know

All of us have a special item we would like to purchase for our homes or lives. The old couch in your living-room that needs to be replaced or the vacation you’ve been thinking about but have put off for years because it is so expensive. It can be difficult to pay for these large expenses, but you may find that a sinking account is a more effective way.

Sinking funds are a great way to save money for both individuals and families. This is an important tool for saving money. This strategy is for those who are looking to gain more peace of mind and better manage their finances.

It is never too early to start sinking funds. The US personal saving rate for May 2021 is 14.9%, which shows that Americans are saving more. This unusually high rate is due to spending restrictions caused by pandemics. It was 7.6% at the end 2019. Why not make your money work harder for you? It is simple to set up a sinking funds and it will help you save for future large purchases.

What is a Sinking Fund?
Sinking funds are a great way for bondholders and companies to reduce risk. When corporations are looking to raise capital, for example, they can issue bonds that mature in 20 or 30 year. Bondholders get coupons every two months and their principal at maturity.

A trustee oversees a sinking-fund for many bonds. A trustee sets aside money periodically for repayment of principal. This eliminates the need to make a large cash investment by the company when it matures.

The fund reduces the risk that the company will default if they don’t repay the principal to the bondholders. The bondholder is protected and secure knowing that the company will pay their debt. Sinking funds allow a company raise capital at a lower rate of interest to bond investors. It improves the creditworthiness of a company.

Your Household Sinking Fund
You or someone else in your family could create a sinking account, dedicating an existing savings account to a household expense which may be too big to cover without borrowing money. Later, we will explain how your sinking funds differ from your emergency fund.

Your sinking fund will be used to purchase the couch, and not another expense. You plan to contribute monthly to a sinking fund to purchase a couch. Everybody has a budget, a lifestyle and a timeframe to get the couch, or whatever you want.

You can achieve your goals and dreams without feeling guilty. If you want to buy a $1,500 sofa within 12 months, your monthly goal would be to save $125 each month. Divide the amount you estimate to spend into the monthly saving that you intend to deposit in the respective account.

It is more tempting to use your credit card for large purchases if you don’t have a reserve. You would either have to pay off your entire card balance or risk a growing card balance at high interest rates. Setting up a sinking account for purchases has more advantages than adding to your debt.

Sinking Fund Vs. Emergency Fund
Your sinking fund is a safety net, but it serves a different purpose. A savings account is used to set money aside for an emergency fund. This can be for unexpected expenses such as a boiler breakdown, medical bills, or pet surgery. By definition, the timing and amount of an emergency are not known. You have to continue paying your bills, rent or mortgage. Unexpected events can disrupt your finances. Your emergency fund should cover at least six months’ worth of basic needs. You need to be able to access liquid assets quickly.

Sinking funds are used to save money for an upcoming purchase. Your sinking fund will usually be for a certain amount. You have saved for this and know when it will happen. It is not the point of a sinking account to use your emergency fund or general savings.

You can use your savings to pay for bigger items, such as a car, house or college. Dollars can be manipulated and put into a sinking fund for a house or car down payment. Sinking funds can be set up for different categories, such as holidays, Christmas, vacations or charitable donations. You can also have sinking fund by being more specific.

Kitchen remodeling
Sofa
Flat-screen TV
Refrigerator
Maintenance and repair of automobiles
Payment in advance for a Car
House Down Payment
Pet bills
Taxes
Vacations
The decision to label the sinking fund is personal and depends on your household’s savings goals.

How to Set up Your Sinking Fund
Budget Review
You should have a firm grasp on your household budget before you set up your sinking funds. Budgeting helps you understand your income less the fixed and discretionary expenses. Rent or mortgage payments, utilities, loan repayments, and savings are all fixed living expenses. You should have a budget that includes “savings” for yourself. You may need to separate your sinking and emergency funds depending on the level of detail in your budget. Choose a budgeting method that suits you.

You have less control over fixed costs. On the other hand discretionary spending is dependent on how much money you have left. Learn more about budgeting methods here.

  1. List your planned purchases
    List the categories of sinking funds and break them into smaller items. Decide the target amounts of each. Your sinking fund will be named after its discrete type. Some funds have larger amounts and longer timeframes. Divide the totals of each type by the number of months you plan to purchase the item. If you plan to save for the down payment on a new vehicle in two years and estimate that the car costs $38,000 then you will need a $4,500 down payment. This is about $190 per month for the next two years, or 24 months.

You can have as many sinking fund accounts as you want, but I caution against managing too many. It is all about organizing your finances so that you can be more efficient and effective. You are the manager or trustee of the funds, just as you would be in a sinking bond.

  1. What You Can Buy With Your Savings
    You can either open separate sinking funds for each type, or you can have a large sinking account with sub-accounts. Remember that sinking funds are different from your emergency fund, savings account and other accounts. You should choose accounts that are easily accessible and liquid. They should also be similar to your emergency fund account.

You will have different accounts for each type of sinking fund. The target amounts and the timeframe are also different. If you’re saving for a home renovation or down payment, you may be looking to build up a five-figure fund. You can then look at higher-yielding savings accounts or money market accounts. For smaller purchases or shorter timeframes avoid accounts with minimum balances and fees that penalize not maintaining the required balance. You want to ensure that the funds are safe and liquid.

Use sub-savings accounts
Some banks such as Ally allow you to set up multiple sub-savings account when you want to save for specific purchases. You can automate the transfer of money to each sinking fund based on your monthly contribution. Transferring money is a great way to simplify the process. You will receive more monthly statements. You should carefully review the account information, including fees, minimums and if there are any differences in APYs.

  1. Need an FDIC-insured account
    What ever you decide, make sure that each sinking fund is in a FDIC-insured account and easily accessible. For longer-term investments, you should look for higher returns and minimize any fees.

A Sinking Fund Has Many Benefits

  1. Better Budgeting
    It is easier to plan discretionary expenditures when you know your budget and your fixed costs. You can determine how much you can put into your sinking fund without it becoming a burden.

Budgeting will help you plan your spending and savings. When you set a specific target for saving money, it is easier to do so.

  1. Conscious Spending
    You are basically planning to purchase something for your life or home. When you save for something, it is an act that requires conscious or mindful expenditure. You have decided on the couch that you want to buy. You also have a specific plan and are focused on it.

Comparing prices and taking the time to do so makes the anticipation of a new product that you want less stressful. Salespeople won’t push you to make a purchase that you will regret. You are in greater control of your finances and more willing to negotiate.

  1. Delays Instant Gratification
    Social media ads are affecting our brains, and we feel the need for immediate gratification. The present bias is a major factor in our tendency to seek immediate pleasures. We tend to prefer the present, with its immediate rewards, over the future. Planning can help you overcome the tendency to overspend by weighing decisions.

You can put off instant gratification by having your sinking funds in place. Your mind is not only on the purchase you expect to make, but also on other things. When you set goals in one area of your life, it makes your wants and needs more focused. Achieving a goal can be very satisfying.

  1. Avoids Adding Debt
    Credit card debt can rise dramatically if you overspend. The cost of managing card balances is high. A household sinking account can be used to avoid using credit cards for big ticket items. To improve our financial health, we can increase our monthly savings through earmarking funds to be contributed to a specific interest-bearing account.

Creditworthiness can be improved by saving first, then spending later and avoiding debt wherever possible.

  1. Enjoy Peace of Mind
    Peace of mind is worth its weight in gold. Planning your expenditures on important things that you want to do or buy can improve your mentality.

Drawbacks

  1. You don’t want to have too many sinking funds
    You may get good at organizing your finances. You may find that you are wasting money on sinking funds and overlapping uses. This reminds me an advertisement for Post-Its, which stated that they were to be used “for little things you will forget,” but then you see yellow Post-Its on people’s heads. You can see the picture. You don’t need to cause chaos. Your savings can be organized using the sinking fund method.
  2. Sinking funds are not interchangeable
    Separate sinking funds are created for each. Continue to contribute to each fund based on your estimates. Label them as discretely as you can to avoid confusion. If you estimated $2,500 to buy a couch, but you found one that you loved for $1,800 instead, you can use your savings in other areas. You may underestimate or overestimate your expected costs, so don’t be afraid to make adjustments.
  3. Keep emergency funds separate
    It is important to have an emergency fund. This fund has a different purpose than a sinking fund. Transferring money from your emergency fund to your vacation account is a bad idea. This is cheating. If an emergency occurs, you’ll want the money to be available in a safe place.
  4. Save for other goals.
    Your long-term financial future depends on your ability to save for retirement and invest. Automate your Roth IRA and 401K contributions, if your employer sponsors the plan. You should also invest some of your money, whether you manage the account yourself or you have a financial advisor to do it.

These accounts will grow faster over the long term than savings accounts depending on the investments you make (e.g. stocks, bonds, and real estate) and they benefit from compounding.

This article was originally published on Wealth of Geeks. It has been republished by permission.


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