Sinking Funds

Nobody likes running into unexpected expenses — least of all when they derail a budget that was ticking along so well. Experiencing setbacks in your financial progress can really impact your motivation and momentum, especially if you’re on a debt-free journey or pursuing some financial freedom. Luckily, sinking funds can help you prepare for anything — well, almost anything. Let’s dive into everything you need to know about using sinking funds in your finances.

What are Sinking Funds?

Sinking funds were traditionally used by governments managing national debt. Yes, really! In fact, they’ve been used since the 1700s. In more modern times, they’re used by companies issuing bonds to help them prepare to pay them back in the future by spreading the cost over time. And now, the same concept has trickled down into the personal finance conversation. Many savvy budgeters use sinking funds to help them set aside money for things before they actually need them. In a way, it’s a bit like reverse debt. Instead of taking out debt and paying it back until the balance is zero, you’re setting aside the money before it needs to be spent, so that you’re ready when the expense comes due.

Sinking funds are commonly set up for things like:

• Car repairs
• Pet expenses
• Travel/holidays
• Medical expenses
• Gifts
• Home repairs
• Larger annual bills, like insurance premiums

However, you can also set up sinking funds for absolutely anything you like. You might want to set up a sinking fund in case your favorite artist announces tour tickets, or for spontaneous decisions that you want to be financially prepared for.

Sinking funds are a proactive approach to managing money. Rather than passively waiting to run into expenses and deciding how you’ll afford them, sinking funds look ahead.

How are Sinking Funds different from savings?

Good question! Sinking funds and savings funds have a lot in common. They’re pots of money you set aside from your regular discretionary spending. The key difference, though, is that sinking funds are designed to be spent on something specific. Where your savings might be something you amass over time with no specific plans to spend them in the short term, your sinking funds are more of a way of reserving money for something you know you’ll spend on.

Savings have much more of an accumulative intention. You want to amass as much as possible. Sinking funds, however, almost work backwards.

Now let’s say you also have a sinking fund for car servicing expenses. If you get your car serviced once per year and you tend to spend around $1,200 on maintenance at each service, you could allocate $100 per month to your car service sinking fund. The idea is that by the time you get to your car service, the money has been pre-saved, and is ready to spend.

See the difference? It’s subtle, but important.

How Sinking Funds work

Sinking funds work by reverse engineering your savings allocations based on what you need money for. Here’s how to set one up:

Step 1: Take a large expense you want to be prepared for in the future, for example, buying a new laptop when yours needs replacing, or like our example above, car repairs.

Step 2: Establish what that will cost. In some cases, this is simple. If a new laptop costs $2,000, that’s what you’ll need. However, if it’s something you’re not completely sure how to cost up, you’ll need to do some educated estimating. Like our car repairs example above, you might look back at how much you’ve spent in the past, or consider how much would make you feel comfortable to have saved when that expense falls due.

Step 3: Assign a date to when you want to have your sinking fund fully funded. When do you want to buy the laptop? When do you get your car serviced? That’ll be the ‘maturity date’ of your sinking fund.

Step 4: Calculate how many times you get paid between now and that date. For example, if it’s one year away, that might be 12 paydays if you’re paid monthly, or 52 paydays if you’re paid weekly.

Step 5: Divide your total by the number of paydays between now and your maturity date. For our laptop, that’s $2,000 divided by 12 months.

$2,000 ÷ 12 months = $167 per month (rounded up)

Step 6: Set aside your allocation each payday, and by your maturity date, your sinking fund will be fully funded.

Step 7 (optional): Sweep and recalibrate. Sometimes our sinking funds will total more than we need to pay out, particularly if we’ve had to use estimates, or if we’re preparing for an uncertain expense like car repairs. Each time your sinking fund matures, you need to sweep, repeat and recalibrate.

Pros and cons of Sinking Funds

As with all things personal finance, there are upsides and downsides. Let’s take a look at what’s great about sinking funds, and what needs to be taken into consideration.

Pros

• Certainty and peace of mind. Setting money aside before you need it is one of the best things you can do for your financial wellbeing. Being prepared reduces money anxiety and helps you feel in control of your financial outcomes.
• Reduces reliance on credit. The more prepared you are for big expenses, the less you risk relying on credit or overdrafts to make ends meet.
• Helps build momentum. Achieving your financial goals is all about making consistent progress — but running into unexpected costs can stall your momentum and leave you feeling deflated. Knowing you’ve planned ahead for bigger costs can help keep your momentum up.
• Teaches mindful spending. Setting aside a small regular amount towards larger purchases teaches you delayed gratification and mindfulness around parting with your cash.

Cons

• False sense of security. While sinking funds certainly help you prepare for upcoming costs, we can never be 100% sure what’s around the corner. Unexpected events do happen, so don’t put pressure on yourself to be prepared for absolutely every outcome. You can only do what you can.
• They can be inaccurate. Some costs end up coming in higher than we anticipate, which can mean your sinking fund isn’t adequately topped up. If this happens, learn from it the next time you reset your sinking fund to prevent it happening again in future.
• Risk of overcrowding your budget. You can have as many sinking funds as you like — but doesn’t necessarily mean you should! Having too many sinking funds could overcomplicate your budget.

The brain bit: The Sinking Funds mindset

Sinking funds are not only a great addition to your budget mathematically — they’re great for your mindset too. Here’s how sinking funds work for our brains.

Momentum. The concept of momentum is that an object in motion stays in motion. When it comes to money management, momentum is important. When things are working for you, you’re more likely to keep striving towards your goals and engaging in the behaviors that create the outcomes you want. Sinking funds help you stay on top of bigger expenses, which creates momentum by giving you the best chance of budget success. Plus, you get to experience the satisfaction of having money saved up for an expense when it falls due.

Proactive, not reactive. Sinking funds are a proactive approach to managing money. Rather than passively waiting to run into expenses and deciding how you’ll afford them, sinking funds look ahead. Being proactive applies a positive, action-focused lens to your finances.

Financial wellbeing. Research on financial wellbeing suggests that it comes down to both objective and subjective factors. The objective aspect is the numbers side of things — spending less than you earn, minimizing debt and maximizing savings. Basically, the bit where you actually have money to cover your expenses. The subjective aspect is your feelings and perceptions about your finances. Sinking funds hit both of these aspects of financial wellbeing. Objectively, you’re setting money aside for future expenses. Tick. Subjectively, you’re increasing your positive feelings about your financial situation, and fostering a sense of autonomy and control over your finances. Tick, and tick.

Who Sinking Funds are best suited for

Sinking funds work for all kinds of budgeters at all stages of their financial journey — in fact, most people continue using sinking funds over the long term, because they work so well — but they’re particularly helpful when you’re starting out. One of the biggest pitfalls for new budgeters or people on a debt-free journey is large expenses that derail progress and leave you feeling defeated. Learning to spread larger expenses out over a longer period of time and contributing to their sinking funds every payday can really help build your confidence with your budget. There’s no better feeling than getting your insurance renewal notice and having the money already set aside!

Sinking Funds 🤝 PocketSmith

Sinking funds and PocketSmith are like hot apple pie and ice cream. You can use categories to assign your sinking fund related transactions, and watch your balance grow with live bank feeds displaying your transactions and balances as you go. For annual expenses, you can even set an annual budget amount, and PocketSmith will automatically show you what that equates to weekly and monthly.

Sinking Funds: How to nail them

We want you to crush your sinking funds, so here are our top tips on how to nail them.

• Keep it simple. Don’t overcomplicate your budget with too many sinking funds. Start with around three key sinking funds and get used to how they fit into your budget and money management.
• Separate your sinking fund money from other spending money. When you’re saving for something in the distant future, it’s sometimes tempting to borrow that money from yourself and pay it back later. To prevent this, keep your sinking fund savings somewhere separate, like a different bank account, or even in cash envelopes.
• Review regularly. The key to successful sinking funds is making sure you’re stashing the right amount. Keep track of your sinking funds and how they measure up to your real spending, and adjust them each time they mature.

Sinking Funds: How not to fail them

The opposite of nailing it? Failing it. Here are some potential pitfalls to avoid.

• Don’t underestimate costs. Where possible, use conservative estimates when calculating your sinking funds. If you’re not sure whether you’ll need $1800 or $2000, it’s always safer to over save than undersave. Go for the $2,000. You can always sweep your surplus later.
• Don’t forget inflation and price increases. Adding a buffer of 5-10% to account for inflation or other price increases that occur before your sinking fund’s maturity date.

The PocketSmith verdict: 5/5

We’ll be honest — we love a sinking fund. They’re a staple in any good budget, and they help spread the cost of bigger expenses that can easily become budget busters. Don’t sleep on sinking funds!