If you listen to personal financial advice very long you are bound to hear the term “sinking fund” tossed around. Unfortunately, it is usually mentioned in passing as if everyone knows the answer to the usual question, “What is a sinking fund?” Read on to learn more about sinking funds, and learn how they can save your finaces from those infrequent, household expenses that manage to sneak up on us every few months.
A sinking fund, in the context of corporate finance, is a sum of money identified by a corporation to be held aside over time for repayment of some item – usually preferred stock or a bond issue. Companies do this to make it less painful to repay a bond at maturity by moving incremental amounts into this fund while the bond is outstanding, rather than having to come up with the full face value when its time to pay.
In the personal finance world we can use sinking funds to help prepare for large, infrequent expenses that come along throughout the year. A prime example of such an expense is car insurance. Many insurers allow customers to pay monthly premiums for a convenience fee (my company charges $4.00 per monthly payment). I can easily save $24 by rejecting the monthly payment arrangement and agreeing to pay once every six month – effectively saving money on car insurance. But this means I have to come up with a hefty sum of money twice a year to cover the premium. This is where sinking funds can help.
Some prefer to create a separate account for each sinking fund, but I prefer to create one account, and then simply separate the money using something like Microsoft Excel – a paper ledger will also do the trick. The sum of my individual sinking funds adds up to my account balance.
Around the first of the year I opened an ING Direct Electric Orange online checking account to house our sinking fund. Up to now I was using my emergency fund to cover a lot of these expenses, which is not really what emergency funds are designed to do. Here’s a look at just four of the funds we have created so far, along with the fund balance five pay periods into the year Note, I’ve changed the amounts to keep you guessing:
Notice that the larger annual amounts, such as vacation at $1,500, don’t seem quite as scary when you only have to set aside $58 per pay period. I get paid every other week, so 26 times a year $110 is transferred from my paycheck to my account at ING and allocated to those four funds. When those items are due, I simply write a check (or use online bill pay or my debit card, in the case of ING Checking) to transfer the amount due, reseting the fund balance to zero. Interest earned from the sinking fund is swept into my savings account each month and added to the emergency fund.
It does take some discipline to leave the amounts alone as they accumulate throughout the year. If you do need to access the account in an emergency, you can always cash in and reset the payment amounts based on the number of pay periods remaining until the item is due. But for the most part I leave the funds alone because having the amount in place when the bill is due is such a nice feeling.