LESSON 15: Sinking Funds

In Lesson 14, we discussed thinking through the intentions you have for your money. During this exercise, you might have looked through the list of categories and realized all expenses are not created equal. Your mortgage expense, your groceries expense, your automotive repairs, and your catastrophe categories are not forecasted the same.

Some categories represent a consistent expense (in both amount and frequency). Your rent/mortgage payment would be a good example of this. Your payment might be due on the 1st of each month and is the same amount each month (although this amount might be adjusted periodically). For this type of expense, you can easily schedule your payment and anticipate when you'll need to have the money available. Other examples might include cable, cellphone, and internet service, streaming subscriptions, and loan payments.

Other categories are variable in amount but still rather consistent in frequency. These include categories such as food expenses, utilities, gasoline, pet care, and haircuts, among others. For this type of expense, you can often anticipate when you'll need to have the money available, but the amount might fluctuate up or down depending on your current needs, your current usage, the current price, etc. Predicting how much to set aside is more challenging.

Many more are categories that are only paid occasionally, whether they are consistent or variable in amount. For these expenses, the challenge is having enough money available at a future date when the money is needed. Categories might include auto/life/property insurance premiums, auto/property maintenance and repairs, auto registration, entertainment expenses, clothing purchases, dental/medical/vision expenses, and a variety of others.

For these less predictable categories, it is helpful to establish sinking fund holding accounts. If you have taken a basic accounting class, it might be helpful to imagine some of these categories as "payable" accounts, or future liabilities. If you are not familiar with accounting, a sinking fund is simply an envelope (either physical or digital) where money is set aside to cover a future expense. This could be a known amount at a known time, or an unknown amount at an unknown time.

Sinking funds would not be necessary for the items listed in the paragraph discussing consistent expenses because you could simply make the payment. For the next group of categories discussed, sinking funds would be helpful in smoothing out your monthly ups and downs. For example, if you typically spend more money on utilities in the winter than in the summer but know your costs for the entire year last year was $2,400, you could then setup a sinking fund where you place $200 per month. As the summer utilities bills paid from the fund, the remaining amount starts building a positive balance in the fund since the bills are below your monthly contribution, and those saved funds help pay the higher winter utilities as they come in higher than the $200 you continue contributing each month.

Sinking funds are also helpful for the third group where funds are needed for a future expense. When the amount is known, such as needing $1,200 in 12 months to pay for a planned vacation, you can easily determine the requirement to put $100 per month into a Vacation Fund. This can be used for any known expense. Maybe you pay for your auto insurance every 6 months (and receive a discount when paid in full), determine the monthly amount needed to make the payment in 6 months and put the money into your Auto Insurance Fund. Let's go crazy and decide you want to buy a new car in 4 years without needing to take a loan. Estimate how much that vehicle will cost and divide by 48 months to save money into your New Car Fund. Create as many sinking funds as you'd like.

The final sinking fund is for expenses you neither know when they'll occur nor how much they'll cost. This sinking fund is simply called an Emergency Fund. The ultimate goal is to have several months worth of expenses saved in this fund in the event of job loss or other unpredictable situation. Emergency funds are not meant to pay for predictable expenses we simply failed to plan for. New tires is not supposed to be an emergency, tires only last a certain number of miles and replacement is predictable. A new water heater or roof on your house isn't supposed to be an emergency (unless damaged from a storm) since their lifespan is predictable. Occasional dental or medical treatment isn't supposed to be an emergency since insurance deductibles and cost shares are predictable, except in some catastrophic circumstances.

For more information on sinking funds, watch this recommended video from The Financial Diet.

Once again, developing a plan for your income helps you reach your desired outcome of lower stress regarding financial worries and increased happiness when you can spend money on the things you value without guilt that "the money could be used on something else" because you've thought through the alternatives and made a plan. Plans take time to fully develop and to see substantial results. Setbacks sometimes occur. But remember that "Even in small numbers, where there is consistency over time, change can happen." - Serge Muscovici