Sinking Fund Eases Strain Of Annual Expenses

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.

Comments

  1. Nice explanation of how you use a sinking fund. I wonder why you bother sweeping the interest into your emergency fund monthly. That seems like a lot of extra maintanence to me for what probably amounts to about $10 or $15 per year. Why not just leave it in there? Or reduce your contributions to one of the categories by the annual interest you expect to make?

  2. This is a great idea. I have an account that an amount of money is put in each pay. Automatic payments come out of this account and there has always been a bit extra. Recently we had to move our health insurance to fortnightly payments because we couldn’t make a three month payment. It is coming out of this account. Now I am going to build it up as a sinking fund for all those biggies like the car insurance that always comes the same time as the rates, school fees and a million other bills.
    Thanks frugal Dad, I keep picking up ideas that really help

  3. Good advice. I’ve been using a similar method to save for future vacations and expenses I know are coming. Most recently as well, I’ve created a little savings fund for the tax relief money coming each paycheck due to Obama’s package. At the end of the year, this will be a nice “bonus” that we can inject into a vacation fund or down payment for a home.

  4. Hey, FD. I was just balancing out my sinking fund– it’s called (most creatively) Irregular Savings Allocation Fund.

    I don’t just use it for those measured expenses though– we have 13 categories in our spreadsheet. Christmas and car tags, yes, but also car repairs and medical bills.

    I think expanding the use of this for any irregular expense, even if you don’t know how much it might be, can take a lot of pressure off your budget. Even school supplies in August represent a significant chunk of change– unless you’re saving ten bucks a month for them.

    The nicest thing about this is that now there’s so much money in there, if the car really needs major work, we can borrow from ourselves. In fact, my 17 year old son needs a new car. He’ll have 2 grand saved in a couple of months, we’ll lend the other thousand out of our new car fund, and he can pay us back before we need it. (He’s saved 200 a month on part time minimum wage, so we’ll do the same repayment plan. Long terms on loans, I said, not good. How much interest? he asked. That’s my boy.)

    My water bill comes quarterly, too. It’s incredible the amount of odd expenses.

    I do use separate sinking funds for income taxes (self employed) and real estate taxes. Seems important to keep those absolutely separate from everything.

  5. The one thing overlooked here is that many people live from pay check to pay check and to take money out for future expenses will not leave them enough for current expenses.

    These are the people that need this type of system most.

    For them the best advice would be to break into it slowly. Pick one or two items and start the process. Then over time as they free up more money add to the list.

  6. I’m curious why it is called “sinking” fund? ‘Cuz you’re sinking money away?

    I do this with my vacation, property taxes, car repairs, car insurance and other annual/irregular bills. And I divvy the interest on the account up between the various categories for a buffer. My reward is that if I have extra $ left over in that category when the bill is paid, I get to keep half. :) The other half stays in that category for the following year in case of a price hike or something.

  7. I do the exact same thing with my auto insurance premiums (though they seem to keep going up, making it harder to estimate need) and it works well. I don’t even notice the small amount of money missing from my paycheck, and when the time comes to pay the bill, if I’m a little short I can just move some money around to cover the balance. That hurts a lot less than having to come up with a lump sum payment.

  8. Just when I thought I knew just about everything there was to know regarding personal finance… This post is absolutely GOLDEN. The sinking fund would have helped me tremendously as I’m now looking at a $400 withdrawal from my checking account next week to cover my federal taxes.

  9. @Jimmy: Though I didn’t mention it in the post, your example of estimated taxes is another great use for sinking funds. I siphon off a percentage of my online earnings into this account to pay quarterly estimates on top of my regular earnings. I was not as good about this last year and it’s making April look quite painful this year!

  10. “Note, I’ve changed the amounts to keep you guessing…”

    Haha, yea you did change those values. You don’t take vacations any more FrugalDad. :-)

  11. Sinking fund is very similar to teh depreciation fund being used by large corporates. It works on the same principle of saving regularly for replacing the high ticket purchase item like machinery etc. It is an important concept in accountinga nd works very well.

  12. This is a great post for people who have troubles budgetting for those big annual expenses.

    I do something similar. I don’t have a separate account for it, though. I just keep track of it all in an excel spreadsheet. Every paycheck is allocated to various budgetted spending categories, or set aside for expected bills. As I spend the money, it’s deducted from the allocated ammounts. I make sure my allocations always balance out with my account ballances. It’s a pretty anal system, really, but the accounting student inside me loves it .. heh.

    I also find budgeting for things bi-weekly, as paychecks come in, keeps me honest during those two three-paycheck months a year. Instead of blowing the third paycheck on beer and popcorn, my regular ammounts for bills, etc., are still allocated out.

  13. Interesting! I didn’t know there was a name for this habit. I always called it “the monthly set-aside.” Once your mortgage is paid off, you have to come up with the money to pay the hefty annual property tax bill, plus the homeowner’s insurance and the astonishing auto insurance and the annual hit for car registration. I put a single amount aside each month to cover all three of those costs.

  14. Bunch of idiots. Just don’t spend what you shouldn’t be spending, Stupids. Then the $ will be sitting right there in the account that you use for writing checks, when you need it.

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