When I studied abroad during undergrad, I traveled a lot more often than expected and had to take money out of my emergency fund to pay for my travel expenses. If I had known what a sinking fund was back then, I would have been better prepared and allocated a more reasonable amount of money towards my study abroad trip.
While I rebuilt my emergency fund over time, I did take a big hit that semester and ended up having less money set aside than I would have liked for real emergencies. Although an emergency fund and sinking fund may sound similar, they are tools meant for different purposes. We will explain what an emergency fund and a sinking fund are, their key differences, and ways to build them.
- An emergency fund is for unplanned purchases, such as job loss or car repairs. The rule of thumb is to save at least 3-6 months of your monthly expenses for your rainy day fund.
- A sinking fund is strategic and meant for one-time expenses or known expenses, such as a vacation or home down payment.
- The main difference between a sinking fund and an emergency fund is that sinking funds are strategic while emergency funds are for the unknown.
Understanding Emergency Funds
With the ongoing effects of the pandemic, having an emergency fund is more important than ever. As its name implies, an emergency fund is money you set aside for emergencies, such as an unexpected medical bill, car breakdown, or a lost job. Think of it as a financial safety net meant to protect you when a crisis hits.
The rule of thumb is to save at least 3-6 months of expenses in your emergency fund, though it may vary based on your financial situation. If this seems like a lot of money, start by setting aside as little as $20 a week. That way, you will have something to fall back on when things go wrong.
How to Build an Emergency Fund
Your first step is to figure out how much you want to save. Go through your last few months of expenses and calculate the average amount you spend each month. Then, separate your expenses into needs versus wants and categorize them. For example, rent or mortgage payments, utilities, and groceries would fall under needs, whereas subscription services or dining out would fall under wants.
By categorizing your spending, you can get a clearer picture of what items your baseline budget includes. When calculating the amount you need for your emergency fund, it does not necessarily mean you need to save at least 3-6 months of your monthly income. When times get hard, assume that you will need to cut some discretionary spending to get by.
Once you have the number, start transferring money towards that fund each month. We recommend keeping this money separate from your checking account and preferably in a high-yield savings account like HM Bradley or Ally Bank instead. That way, you will not be tempted to spend it.
It may feel impossible to get started, but you can always start small and build from there. When I first started saving as a kid, it was only a few dollars here and there, occasionally maybe $20. Now that I’ve built the habit into my monthly routine, I can save a lot more from my elementary school days. As long as you stay consistent, you will be on track to financial security.
Understanding Sinking Funds
Sinking funds are similar to emergency funds in that they are both meant to act as financial safety nets and keep you on track to reach your financial goals. But, sinking funds are a more tactical way to save money.
The way it works is that you will regularly set aside a little bit of money in one or multiple categories to get used later down the line. This fund is separate from your emergency fund or savings account it should be for specific goals.
By setting aside a sinking fund for expenses you anticipate to have later in the calendar year, you will not have to dip into your emergency fund like I had to before. For example, if you know you will be going on vacation in five months and think it will cost about $2,000, you would save $400 per month for the next five months.
Common Sinking Fund Categories
Common types of sinking fund categories are planned expenses (such as a new car) or annual expenses (such as school tuition). Even if you do not have an exact number in mind, it’s still worth setting up a sinking fund for big expenses. How many sinking funds you decide to set up is up to you. But, they are supposed to help you not be overwhelmed when the bills hit.
Sinking fund examples include:
- Expected medical bills
- Home repairs or remodels
- Car repairs
- Insurance premiums
- Long-term debt
- Wedding expenses
- Holiday spending
- Pet expenses
- New appliances
- Parties or concerts
- School tuition
- New appliances
- Annual subscriptions (ex. Amazon prime subscription, Costo membership, Rakuten Viki, etc.)
This list is by no means exhaustive. You can create a sinking fund for any financial goals you want!
How to Build Sinking Funds
You can build sinking funds in four easy steps:
1. Decide What You Are Saving For
The first step to building a sinking fund is deciding what line items you are saving for. If you feel overwhelmed, step back and start with the categories you value the most. Then, build from there. For example, you can have a sinking fund for each planned expense, such as your annual subscriptions, car repairs, medical bills, large purchases, etc.
If you find it challenging to figure out the exact costs, look through your old bank statements to get a good sense of your spending habits. Once you know how much you have been spending, it will be easier to figure out your goals.
2. Decide Where to Hold Your Sinking Fund
Once you have decided what you are saving for, you may want to open a separate savings account dedicated to holding your sinking funds rather than putting the funds into your regular savings account. That way, you will not dip into your sinking funds and use them for unrelated expenses.
If you decide to open separate savings accounts, make sure they do not require a minimum balance and are easily accessible. The last thing you want is for monthly fees to eat up your funds or for your money to get locked up when you need it most. For example, if your car breaks down, you would probably need cash quickly to cover the costs. On the other hand, your down payment for a home can be in a less liquid account, such as the stock market, because you will know in advance when you need the funds.
3. Decide How Much to Allocate
Next, you will need to decide how much you want to allocate toward each sinking fund. That will probably depend on your financial situation and goals, whether it’s saving for a vacation, getting a new car, home repairs, or other big purchases. It may be harder to determine the actual cost for certain expenses, such as medical expenses. In those cases, make an educated guess and put in enough money until you reach that amount. Then, replenish the fund as needed.
To determine how much to save per week or month, take the total amount you need per fund and divide that by the number of weeks or months you have until you need to make the purchase. For example, if your best friend has a destination wedding coming up in four months and you anticipate it will cost you $1,000, then you should stash away about $250 per month until then.
4. Set Up Your Sinking Fund in Your Budget
Lastly, you need to incorporate the fund into your monthly budget. Whether you use a spreadsheet or an app like Mint or Personal Capital, write down your sinking fund line items in your budget. You Need a Budget (YNAB) is a popular app that has a system designed to track various saving categories. Ally Bank is another tool you can use with a high-yield savings account that has “buckets” for different savings categories.
How often you decide to set money aside for your sinking funds is entirely up to you. However, we recommend stashing away money into your funds regularly, whether weekly, monthly, or quarterly. That way, you will be on track to reach your goals.
Benefits of Sinking Funds
Regardless of if you are a spender or saver, anyone can benefit from different sinking funds. With a sinking fund, you can save for anything you’d like. You can be as specific as you want to make sure you cover all your needs and wants.
You can make spending money fun and less stressful. Whether you want to purchase Coachella tickets, invest in your hobbies, or donate to charities, making room to accommodate these expenses ahead of time will save you the headache of unplanned credit card bills.
Because you are saving for things you already anticipate, you will feel less guilty when you make larger purchases. When I first bought my Nintendo Switch, I had contemplated it for a long time because I did not think to have a sinking fund. So, when I finally caved and bought it, I felt like I spent too much money upfront. As you start saving strategically, your fun purchases will actually be exciting, and you will not need to deal with any guilt or frustration from spending money.
Sinking Funds vs. Emergency Funds
Simply put, a sinking fund is a strategic saving account, while an emergency fund is for unexpected expenses. You are saving for planned expenses with a sinking fund, so the money you set aside has a specific purpose. For example, you would use it for a vacation or a home down payment. An emergency fund is reserved for the unknown, such as urgent medical expenses.
If you already have an emergency fund or monthly budget, adding sinking funds to the equation will help you manage your money better and help you hone in on your financial goals. Both serve as safety nets between you and whatever life throws at you. While you cannot anticipate everything, at least you will have some money set aside.
The Bottom Line
While there are key differences between emergency funds and sinking funds, they are tools to set and fulfill your financial goals. With a bit of patience and planning, you can save up now and avoid stressing yourself out over planned or unexpected expenses. Your future self will thank you for putting in the effort.