You must agree that paying for larger expenses like a wedding, a vacation, or a new car or home with a one-month budget is not easy. You need to save the funds bit by bit, and that’s where a sinking fund comes in.
But what is a sinking fund?
A sinking fund is a systematic way of saving up for a particular larger expense little by little every month. In that case, you must calculate the expense and spread the amount over a given number of months.
Let’s say you want to buy a car that’ll cost you Ksh 1.2 million, and you want to have it in one year. Then it means you’ll have to save Ksh 100,000 every month for 12 months.
So, instead of taking the whole Ksh 1.2 million from your one-month budget (if you are fortunate to earn that much) or borrowing, you can save for it.
Here’s what I’ll cover about the sinking fund:
- What’s a sinking fund in budgeting?
- Why do you need a sinking fund?
- What are the different types of sinking funds?
- How do you create a sink fund?
- How does the sink fund compare to other funds?
Let’s dive in!
What Are Sinking Funds in Budgeting?
Sinking funds are allocations on your monthly budget targeting a future major expense. You save up for the expense over a period of several months without having to mess up your budget.
Ideally, calculate firsthand the expense cost before starting to save for it. Some of the expenses you can set up a sink fund for and budget for every month until you hit the target are:
- A new car
- Home purchase or remodeling
- Christmas gifts
- Birthday party
- Special-occasion clothes
- Wedding expenses
- New car tires
- Family vacation
- Charitable giving
- Plane tickets
- Phone upgrade
- Baby shower
- School fees
The above items only form a small fraction of what you can do with a sink fund. You can set up this fund for any financial good. All it takes is strategic planning, and I’ll help you do that.
Why Do You Need a Sinking Fund?
Whether you are a carefree spender (which you shouldn’t) or a savvy saver, you need a sinking fund, and here are the reasons why:
- Save for almost anything – You are never limited when setting up a sink fund. You can save up for just about anything regardless of how much it costs, as long as you can afford it in the long term.
- Protect your emergency fund and other savings – You wouldn’t have to dip your hand into your emergency fund or any other goal-specific savings when you have a sink fund. You only need to wait until you fully fund your sinking fund.
- Avoid the large purchase guilt – It’s easy to feel guilty about making an unplanned largest purchase because of its implication on your budget. A sinking fund, however, takes away that guilt by enabling you to save up for the expense over time.
- Financial stability – Financial stability comes from careful planning and purposeful budgeting, which is attainable with a sink fund. A sinking fund ensures you don’t spend your other savings, giving you financial stability.
- Create space for fun in your life – Rarely do people have the opportunity to have fun because of the fear of messing up their budget. A sink fund saves you from such concerns by enabling you to save up for a dream vacation, retreat, and just about any other fun moment over time.
- Wealth creation – A sink fund doesn’t just allow you to have fun but also build wealth. That’s the case when you set up the fund to buy a home or remodel an existing one, as you can sell it later at a higher value.
- Avoid debt and associated interest – A sink fund saves you from borrowing to meet a major one-time expense. Since the expense is for the foreseeable future, you can budget for it and save towards it without getting a loan, which you may end up paying expensively due to high interest.
- Debt/bond repayment – Companies also find sinking funds useful in paying debts and bonds. They can set money aside regularly to soften the hardship of paying for debts and bonds.
- Attract investors – A sink fund boosts investors’ confidence in a company. They see it as security which translates to a lower risk. Investors can have their money back if the company becomes bankrupt or folds down.
- Enhances creditworthiness – A sinking fund can boost your chance of getting a bank loan. Let’s say you want a mortgage, and your credit record is not that good; The lender may take a risk with you once they learn you have a sink fund.
How to Create a Sinking Fund?
Sinking funds are probably the most straightforward funds to set up, and here’s how to do it:
Step 1 (Decide On Savings Goal)
What do you want to buy? What’s your bug future expense? Once you decide on it, you can proceed to step 2.
Step 2 (Choose Where to Put Your Sinking Fund Money)
There are many savings options where you could put your sink fund. For example, you could open separate savings account with no monthly fees to avoid chipping away your balance. However, a savings account requires you to be more financially disciplined.
But if you aren’t, consider a money market fund. It’s our best recommendation since it has higher returns and the fund is less accessible than traditional savings accounts.
You can also use mobile options like MSHWARI and KCB MPESA.
Step 3 (Decide How Much Should Be In A Sinking Fund)
Since sinking funds are set up for different financial goals, there’s no standard amount. You need to save what’s enough for your financial goal.
For example, if your goal is to go on a vacation costing Ksh 100,000, that’s what you should save in the long run. And if you intend to spend Ksh 50,000 on your kids’ school fees, your goal should be Ksh 50,000.
Step 4 (Include The Sinking Fund in The Budget)
A sinking fund has to be budgeted for. So, you must include it in your monthly budget to set aside its monthly allocation. But first, you must decide how much to save up each month, and this is where your target amount (in step 3) is essential.
See how much you can save each month to reach the target. For example, if you can spare Ksh 5,000 every month for the sink fund, you’ll have Ksh 60,000 at the end of the year, which you can use for a one-time major purchase.
Step 5 (Start Saving)
Now that you know your savings goal, how much to save each month, and where to save, start saving. Be consistent, and you’ll hit your target.
Types of Sinking Fund
Ideally, we’ve four types of sinking funds which are as follows:
- Specific-Purpose Sinking Fund – As the name suggests, a specific-purpose sink fund is created to meet a particular financial goal. For example, you can set up a sink fund to purchase a house or car or pay for a wedding, party, or school fees.
- Purchase-Back Sinking Fund – A purchase-back sink fund allows companies to buy back bonds from bondholders. Essentially you can buy back bonds at market price or sinking fund price.
- Callable Sinking Fund – A callable sink fund is a type of sinking fund that companies set up for a particular call price.
- Regular-Payment Sinking Fund – A regular-payment fund comes in handy when making a regular payment to trustees.
How Sink Funds Compare to Other Funds
Sinking Fund Versus Emergency Fund
The sinking fund versus the emergency fund difference is black and white. For one, a sinking fund is set up for a specific future expense, which means you must have a particular amount in mind.
On the other hand, an emergency fund is set up for a non-specific or unplanned future expense. So, while you know what you’ll pay for using your sink fund, you can’t tell what you’ll use your emergency fund for, as you’ll be ready for any financial emergency.
The other difference is that while you know that you’ll have to drain your sinking fund at some point once you hit your target, you may never use an emergency fund. And when you do, you’ll have to replenish the fund.
You don’t replenish a sinking fund. Once you pay for your target expense, that’s it. You can only set up another sinking fund for a particular goal.
Sinking Fund Versus Traditional Savings Account
Sinking funds allows you to save up for a more specific goal. While a traditional savings account also allows you to save for a goal, the goal is less specific.
For example, you could open a savings account to cater to your kids’ school fees, next family vacation, anniversary celebration, and a new car all in one account.
Conversely, when it comes to a sinking fund, all these expenses will need a separate sinking fund.
In conclusion, what is a sinking fund?
As shared, a sinking fund is money saved over time for a specific future expense. This expense is mostly larger, which you can pay with a one-month salary as that may wreck your budget.
You also cannot use the emergency fund for such an expense since it’s technically not an emergency. We recommend a money market fund as your savings vehicle because of its higher return rate and low risk.
Talk to our team on social media, and we’ll happily advise you on the best investment to take.