Sinking funds 101
Sinking funds is one of my fave personal finance tools and has been mentioned many times on the blog, here and here. However, after talking about it on Instagram, many of you requested a basic introduction post on the topic - your wish is my demand!
What is a sinking fund?
First and foremost: Sinking funds exist to help with expected, irregular expenses. As opposed to an emergency fund which will help with unexpected emergency expenses.
The term is borrowed from the business world, where it is known as funds set up to pay off debts or bond issues. However, it is just as valuable at the personal finance level.
One example is home repairs. We don't know when it will happen, but we do know that at some point in the future, we will have to pay to repair or replace something in our house, and this can be a big expense.
Another example is Christmas. We do know that December will come, and we do know that it comes with Christmas parties, presents, and big dinners - in fact, the average UK household spend £800 more in December than other months! Unfortunately, 7 in 10 turns to credit to cover the cost, which we know comes with high interest!
What if we had saving pots sat aside for these expenses? Built gradually, without disrupting your monthly budgets? Come December, you have a pot of £800 designated to cover Christmas expenses - imagine! That's exactly what sinking funds are!
As mentioned, an emergency fund is for emergencies and not for Christmas or replacing your laptop. An emergency includes unexpected job loss, a medical emergency, accident-related costs or unexpected bereavement.
Why do you need sinking funds?
Sinking funds help us being thoughtful and proactive in your financial planning. Life can throw financial curveballs at us, even more than one at the time, so having both sinking funds and a solid emergency fund in place makes you less vulnerable.
In addition to financial stability, sinking funds will help keeping your stress level down and maintain financial well-being, giving you a safety net and avoiding living on the "financial edge", just hoping to get by.
Having sinking funds in place will also help you avoid bad financial decisions such as high-interest credit or loans, which comes at a cost of interest, fees and penalties. A survey by Vanguard shows that 10% have withdrawn money from their retirement account, and 14% has taken a loan from their retirement account. You're better than that!
Where to put your sinking funds
You might think you can simply keep an extra buffer of cash in your current account for these expenses, however, setting the money aside will massively help in not spending it. The saying "out of sight, out of mind" absolutely applies to this. Keeping it with your current account will make it challenging to distinguish, increasing the risk of spending it on a whim. Furthermore, you should know how much there is in each of your sinking funds, which further stresses the need to organise this separately.
Personally, I use saving pots in Monzo, which are super easy to set up and manage. The only minus is that it is very easy to move this money to your current account, so if self-control isn't your strength, this might not be the method for you. Also, annoyingly, the total amount of savings pots gets added into the total amount you have on your Monzo, which might be confusing for keeping track of your finances. However, Monzo provides an easy overview of your funds, and you can add photos which helps a lot!
Another option is keeping it in cash. Labelled envelopes might work well, and gives you the option of writing the amount of each fund on the envelope. It does require more work, and might also be challenging if you need to spend any of your sinking funds online.
A third option is one separate bank account. This will require you to keep a spreadsheet to keep track of how much money you've allocated to each pot. This system might work well if you love spreadsheets and you know you'll keep it updated and organised. A plus is that you can probably easily open this extra account with your main bank, so you don't have to deal with opening a new account and new passwords.
Some banks will let you open multiple accounts (e.g. with Capital One 360 you can open up to 25!) This will require more logistics and cause time delay, however, it might be the organised system of your dreams!
Should you set up if you have debt?
This depends on the purpose fo the sinking fund. If you know you will buy Christmas presents anyway, sinking funds is a good way of spreading the cost (while paying down your debt!). However, if you have much debt, you should look at ways to lower your spending thus the required amount of your sinking fund, e.g. by budgeting to spend less on presents and parties in December.
A few practical tips
To get started, write down all the categories you are planning to set up. Populate each category with the required amount and the date you'll need it. For a vacation in September (six months away), where you plan on spending £500, you will have to put aside £84 a month.
Once the sinking fund is emptied, e.g. in December, it is time to make a plan to build it up again. This time, you might be better prepared and have more time, and also have a better idea of how much you need in each fund.
How you set up your funds is up to you and your lifestyle. Personally, I often work on my sinking funds, reorganise, and replan. One day I will have the perfect system! At the moment, I have the following pots: Christmas; presents; vacations; weddings; home repair.
I hope you found this useful!