When Nora Martin was expecting her first child, she wasn’t going to let all the many baby costs bring her down. She had a plan.
“I pretty much wrote up everything that we needed … and then split up the total over six months to see how much we would have to save each month to get to our goal,” Martin said.
This practice of splitting a large financial goal into easier-to-manage chunks has a special name in the personal finance world. It’s called setting up a sinking fund.
What Is a Sinking Fund?
A sinking fund is a pool of money you regularly contribute to so you spread out the cost of an upcoming expense over time.
The term “sinking fund” comes from corporate business lingo. Businesses set aside money in a sinking fund to repay debt or a bond or to prepare for a large capital expenditure.
But you don’t have to own a business to benefit from this money-saving strategy. It’s a smart approach for everyday people to save up for big money goals, future financial obligations and recurring bills outside of regular monthly expenses.
What Do I Need a Sinking Fund For?
Saving money in a sinking fund helps you manage upcoming costs that would overwhelm you if you neglected to plan ahead.
If you don’t have a great deal of disposable income each month, it might be tough — if not impossible — to cover a big expense all at once. For instance, if you waited until December to buy Christmas presents and planned to spend about $800, you might be forced to charge the expenses on your credit card in order to make it happen.
If you set aside money over time in a sinking fund — say, $100 a month for eight months — you can avoid going into debt or having to borrow money.
Having a sinking fund also helps you avoid dipping into your emergency fund when (non-emergent) big expenses pop up. Likewise, you don’t have to pause your progress on other money goals, like paying down debt or investing for retirement.
Sinking funds make upcoming expenses more manageable. And when it’s time to actually spend the money, you can do so guilt free, because you know you’ve been saving up specifically for that purchase.
Sinking funds are also a lifesaver if you have variable income. It can be tough to budget if your income fluctuates from month to month. With sinking funds, you can put money aside during high-earning months and use that cash during low-earning months.
Types of Sinking Funds You Can Add to Your Budget
The sinking fund categories you’ll add to your budget will depend on your individual needs and desires.
In general, there are three types of sinking funds: planned goals, recurring costs and indeterminate future expenses.
Some sinking fund examples that would be considered planned goals include:
New baby expenses
Down payment for a house
Down payment for a new car
These are typically one-time expenses you’ll budget for and can stop saving toward once you’ve reached your targeted amount.
Some examples of recurring expenses you might want to set up sinking funds for include:
Car insurance premiums
Car registration renewals
Home insurance premiums
Summer camp fees
Computer software renewals
Annual fees for credit cards
These are costs you know will come up around the same time each year and need to plan for on an ongoing basis.
Indeterminate future expenses are expenses that are bound to happen but you can’t plan when they’ll occur or exactly how much you’ll need. These can include:
Car repairs or maintenance
Home repairs or maintenance
Do your best to estimate how much you’ll need. Reviewing your past spending in these categories can help.
The Difference Between a Sinking Fund and an Emergency Fund
You should have your emergency fund separate from your sinking funds. They are not the same thing.
Sinking funds are for planned expenses you can anticipate. Emergency funds should only be used in situations that are urgent, important and unexpected.
For example, you’d use your sinking fund money on plane tickets to visit your mom for the holidays. But if your mom got into a car accident and you needed to book a plane ticket at the last minute to help her with her recovery, that’s when you’d use your emergency fund.
How to Save Money With a Sinking Fund
It takes a little math and some organization, but it isn’t difficult to save using sinking funds.
First, you need to figure out the total amount you want to save. Then divide that number by the amount of time you have until you’ll need to spend the money. This will give you the amount you’ll need to set aside in your sinking fund every month (or week or pay period).
For example, if you want to save $1,000 for a vacation over 10 months, you’d need to add $100 to your vacation sinking fund each month.
Since sinking funds typically cover short-term savings goals, you’ll want to be able to access your money easily. Keep it in a high-yield savings account or money market account. Those who prefer the envelope method may keep their sinking fund savings in cash.
If you manage your money with a budgeting app, you can set up your sinking funds digitally. Mint is one of our favorite budgeting apps that doesn’t charge monthly fees.
For longer-term goals, a certificate of deposit or CD is another option to store your money and watch it grow — but only if you know you won’t need to withdraw it before the CD matures. You’ll get hit with penalty fees by taking your money out earlier.
While you’d potentially get the greatest return keeping your savings in a brokerage account, that’s usually not recommended for sinking funds because of the risk of losing your savings due to stock market volatility.
5 Tips for Success With Sinking Funds
Become a pro at using sinking funds with this advice.
1. Separate Your Sinking Fund from Your Main Checking Account
It’s helpful to keep your sinking fund money in a separate account so you don’t wind up spending your savings on Uber Eats or impulse purchases at Target.
2. Name Your Accounts
Giving your sinking fund a name — like “Italy trip” or “house of my dreams” — can help motivate you to keep saving money and not dip into it for something frivolous.
3. Automate Your Savings Transfers
Streamline the process of saving by setting up automatic transfers or direct deposits into your sinking fund accounts so you don’t even have to think about doing it.
4. Apply Windfalls to Sinking Funds
If you receive extra money — such as a bonus or tax refund — add it to your sinking funds to accelerate your progress toward meeting your goals.
5. Prioritize Multiple Savings Goals
When you start listing out all the things you’re saving for in the short term, putting money aside for all of them may seem overwhelming. Prioritize needs — like taxes and insurance bills — over wants — such as vacation or holidays. And know you don’t have to save up for everything all at one. Establish a plan for reaching your money goals that is feasible for you and your financial situation.
Nicole Dow is a senior writer at The Penny Hoarder.
This was originally published on The Penny Hoarder, which helps millions of readers worldwide earn and save money by sharing unique job opportunities, personal stories, freebies and more. The Inc. 5000 ranked The Penny Hoarder as the fastest-growing private media company in the U.S. in 2017.