What is a Sinking Fund? Down to the Nitty-Gritty

Did you know that 99% of Canadians have a bank account with some financial institution?

Whether you’re looking to get a loan or just trying to save up some cash for a car, a house or the likes, a sinking fund is a great idea to achieve your financial goals!

But what are sinking funds exactly? Is it the same as a regular bank account? How is it any different?

Stay tuned are we take a deep dive into the world of savings to help you get a better idea of this financial concept.

Let’s get right into it!

What is a Sinking Fund?

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A sinking fund is a savings method that allows you to save money over time in order to pay for a specific goal or expense. There are a few different types of sinking funds, but all of them work essentially the same way: you dedicate a certain amount of money to the fund every month (or whatever frequency works best for you), and then use that money to pay for the goal or expense when it comes up.

One of the most common reasons people set up sinking funds is to pay for large expenses like a car or a home. Instead of putting the entire cost of the car or home on a credit card and worrying about how you’ll pay it off, you can break the cost down into smaller monthly payments and save up.

Why is it Called a Sinking Fund?

A sinking fund gets its name from the fact that the money in the fund is “sinking” towards a specific goal. Just as a ship sinks when it’s overloaded, so too does money in a sinking fund sink towards a specific goal.

Why Would you Need a Sinking Fund?

Aside from cars or houses, there’s a variety of reasons why you might need a sinking fund. Let’s look at some common  sinking fund examples below:

  • To save up for retirement
  • To save up for a university degree
  • To save up for a certain medical expense
  • To save up for a child’s college education
  • To pay down debt
  • To buy that purse you’ve had your eye on
  • To buy computer gear etc.

As you can see, a sinking fund can be used for just about anything. Just set a goal to buy something within a specific time frame and it will help you motivate yourself to save money consistently each month.

Further reading: Asset Management 101

Sinking Fund vs. Emergency Fund

So, why wouldn’t you just set up an emergency fund?

A sinking fund is specifically for saving up money to pay for a specific goal or expense. An emergency fund, on the other hand, is for unexpected expenses that come up due to the unpredictability of life itself.

To put it simply, emergency funds are basically money that you set aside for unplanned expenses.

If you’re trying to decide whether you should set up a sinking fund or an emergency fund, ask yourself these questions:

  • What are the chances of this expense happening?
  • How much money do I need to save up?
  • Do I have any other options for paying for this expense?

Now, if the chances that the event happens are pretty high and you need to save up a certain amount of money with no other options of paying for the expense, you’re looking at a sinking fund.

If you don’t have any significant event coming and you’re just looking to save up some money for unplanned expenses, then an emergency fund is what you need.

What About a Savings Account?

As we already discussed, sinking funds can be used to save money for specific goals or expenses in the future.

A savings account, on the other hand, can be used for anything. So if you’re not sure what you want to save up for, a savings account is a good option.

Benefits of a Sinking Fund

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Aside from being a great way to save money, sinking funds come with a few other benefits as well. Let’s check them out.

Creditworthiness

A sinking fund can help you increase creditworthiness because it shows lenders that you’re responsible and can save money over time. When you’re applying for a loan, the lender will take into account your debt-to-income ratio. This ratio is the amount of your monthly debt payments divided by your monthly income.

If you have a lot of debt payments each month, it’ll be difficult for the lender to see how much money you have leftover to pay for a loan. But if you can show that you’re already saving up for a specific goal, it’ll be easier for the lender to approve your loan.

Financial Security

The sinking fund can have a major financial impact on your life. By saving up for a specific goal, you’re less likely to have to take out loans or use credit cards to pay for the expense. This can save you money in the long run because you’ll be paying less interest on your debt.

Additionally, sinking funds have a low default risk because the money is dedicated to a specific goal. This means that you’re less likely to miss payments and default on your loan.

How to Start a Sinking Fund?

Now, after revising some of the essential aspects of sinking funds, let’s go over the steps to creating one.

Choose a Category

Let’s say that you want to save up money for a new car. In this case, you would choose the category “car.”

Set a Goal

In this example, your goal would be to save up $10,000 for a new car.

Set a Timeframe

You might want to save up money for a new car in six months, or you might want to save up money for a new car in five years. It’s up to you how long you want to save.

How Much Should I Save Each Month?

Now that you know your goal and the amount of time you have to save, it’s time to determine how much money you need to set away each month. To do so, divide the total expense over the number of months you have until shopping time.

Let’s say that you want to buy a $10,000 car 5 years from now. That’s 5 years x 12 months – 60. Now, we divide the $10,000 over the 60 months and we get roughly $170 per month, which is the amount of money that needs to go into your sinking fund each month in the following 5 years.

Further reading: Open vs. Closed Mortgage

Where do I Keep the Money?

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Deciding where to keep your money depends on whether or not you consider yourself disciplined when it comes to money.

If you are, then a regular savings account will get the job done. If you’re not, though, you might want to think about opening a mutual fund or a money market account.

The latter comes with higher interest rates, but it’s less accessible than e plain old savings account and you won’t be able to pop it open and withdraw money at your convenience.

Finishing Thoughts

Sinking funds provide a number of benefits for those looking to save money for a specific goal or expense in the future. However, if you don’t have a specific goal or a certain amount of money in mind, you might consider other options, such as regular savings accounts or even emergency funds.

FAQ

What are examples of sinking funds?

A sinking fund can be set up for just about anything, including house repairs, medical procedures, vacations and holidays, Christmas gifts, subscriptions and memberships, etc.

Is a sinking fund good?

A sinking fund is a great way to establish a financial safety net. It helps you track financial goals and expenses and helps you stay on budget.

What is the purpose of a sinking fund?

A sinking fund can help you save money for a certain expense you’ve got coming in the future.

What is a sinking fund?

A sinking fund is a savings method that works by setting a certain amount of money each month until you reach your financial goal.

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