how to use sinking fund in your personal finance?

Sinking fund is a term best known in the business world. Lately however I have been hearing of these more and more outside of board rooms. That’s the reason I decided to explain what exactly these are.

I will explain how best to use this in your personal finance and give you a couple of ideas in terms of how to improve your experience and get the most benefit out of a sinking fund. 

what is a sinking fund

Sinking funds find their origins in the world of business. Many businesses and corporations use these to pay off large expenses.

The expenses that companies often face are purchasing or repairing machinery or repaying large dept in a form of a bond.

Creating a sinking fund helps companies to plan these expenses over a longer period of time. This helps to make sure that the lump sum is available for when the equipment needs to be unexpectedly repaired or lenders are coming after their money.

If you live in a block of flats – you might have also heard of sinking fund. This often sits with the person/company that manages all the repairs for your development.

Sinking funds in this instance are there for 2 main reasons – expected and unexpected issues. 

The communal door that all the residents use has a life expectancy of 10 years lets say. The costs of buying a new and labour to get this installed are spread over 10 years and charged every resident monthly/annualy.

On the flip side – there is also a pot of cash for any unexpected emergencies. In case a strong wind damages the roof of the building – residents do not need to find cash at a request to cover £100,000 repair job. Building management can dip into sinking fund and cover the expenses from there.

how to use sinking fund in personal finance

In personal finance sinking funds can be seen as an emergency fund alternative. The key difference between the two – you know what you expect to use this money for.

When it comes to emergency funds – these are in place to help you deal with any unexpected bills that might pop up. These help relief the unnecessary stress and high interest borrowing to pay these expenses. Similar to the damaged roof in the above paragraph.

Sinking funds on the other hand – are there for a specific reason. You know that there is an event coming up that will cost you a fair bit. This way you can plan for it and spread the costs over longer period of time. 

The major benefit of spreading these costs over longer period of time – you don’t feel as if you pay as much in one go. You tend to only allocate a little fraction from every months pay cheque.

Many people who have adopted using sinking funds feel that they are way more in control of their personal finance. They feel that they know exactly how their money is being spent. This also helps eliminate some of the impulse purchases due to you planning major purchases well in advance.

Once the sinking fund has reached its value target – you no longer need to be putting money in. You can then sleep well at night knowing that the cash is ready and waiting for when it needs to be spent. 

Once you dip into that sinking fund to cover the expenses you have – the journey starts once again to reach the desired balance.

what expenses to apply this to

There is no hard rule for what type of expenses to apply this principle to. This will be personal to you depending on your lifestyle.

The frequent categories that people set goals for are large purchases that occur. For example – you want 3 holidays in a year. As long as you know a rough figure of what these will cost – you can start accumulating sinking funds for these over a longer period of time.

There are also some other expenses that occur annually – Xmas and your car MOT. You know both of these events have some degree of costs linked to them. So why not spread the rough costs of these over a 12 month period rather than have to splash out in one go?

The categories you can apply the above logic to are:

• Xmas presents
• Car maintenance
• Property deposit
• New car deposit
• Holidays/experiences
• Bills (in case you pay these quarterly or once every six months)
• New electronic gadgets
• Tuition fees
• Expensive furniture
• House maintenance/refurb
• Expensive item (e.g. watch)

There are many other expenses that you can include in the list above. And not all of the above will apply to everyone. If you have no car or not planning to buy one soon – car related expenses are not even a consideration here.

best practice

My first advice here would be – don’t stretch your budget too much by creating too many funds that need toping up with a lot of money straight away.

If you set a goal that is way too stretching – you are significantly less likely to stick with it going forward. Start by planning a couple and spread their cost over lets say 12 month period. This way you give yourself the best possible chance to succeed. 

In order to make this task easier and clearer – keep this money separately. Create a separate bank account for your sinking funds. Alternatively, some of the new banks are offering sinking funds as a feature. Sterling Bank is just one of the options where separate sinking funds can be created.

I personally would actually consider creating a savings account that actually pays you some interest for holding your money there. As sinking funds might be required at any point in time – make sure your money is always available to you. Don’t lock this in for a period of time.

Currently, with interest rates being high – finding accounts that pay 3-4% of interest per year should be possible. 

By doing the above – not only you make sure you have savings ready for when they are needed the most. You will also be earning some interest on this money. You can either keep the interest as part of your sinking fund or move it to an ISA account to grow this into a significantly bigger pot over time.

summary

Sinking funds are a great tool to help you become more in charge of your money. These can really help you understand where your money goes and how it is spent.

Creating sinking funds can remove a lot of stress in your life from the expenses that might unexpectedly hit you. Also, this is a great tool to save larger amounts of cash for purchases that you can’t afford in one go.

Isn’t it better to be paying into your own sinking fund monthly and earning interest that you can spend how you wish instead of getting a finance on a new car where you are required to pay higher amount monthly to your lender as they will want to earn interest on the money they lent you?

Planning forward can really make a significant difference to you and your relationship with money. Be in charge of your personal finance rather than let it control you and your emotions.