What is a Sinking Fund?

by Neal Frankle, CFP ®

“What is a sinking fund” isn’t just a question accounting nerds like me ask. It’s a question that you should ask too if you want to have a smooth-sailing financial future. Let me illustrate.

Let’s say you paid $1200 for a really nice computer 2 years ago. If you think about it, you’ll realize that someday soon, you’re going to have to replace that computer because it is wearing out all the time. How are you going to pay for that new computer when that day comes?

  • Put it on the credit card?
  • Borrow the money from Aunt Martha?
  • Get an extra job?

All these are possible solutions of course but they all have one flaw in common. They put off looking for a solution until you are in the midst of the problem. My experience tells me that this is an expensive way to solve any problem. When time is short solutions become more expensive. A better course of action is to set up a sinking fund.

What is a sinking fund?

Basically, a sinking fund is an account you open and make deposits into every month. You make those deposits well before you need the money. Think of it as a “Christmas Account” you deposit money into each month during the year so that when December comes around, you have the money to buy gifts.

The benefit of using a sinking fund is that it’s easy to set up and relatively painless to fund. If you start soon enough with plenty of time to build your fund, your monthly deposits don’t need to be all that high and you can still reach your goal.

Set up your sinking fund by using Perkstreet. This is a wonderful and easy-to-use online bank. They won’t charge you any fees to set up your sinking fund and they don’t have any minimum balances.

You can use a sinking fund to replace any asset or fund any activity. All you need is to know:

  1. How much money will you need?
  2. When will you need it?
  3. How much interest will you earn on your deposits in the sinking fund while you are growing it?

Let’s use the example above to illustrate. Let’s say you plan on buying a new computer in 12 months. At that time, you’re going to need $1200. Unfortunately interest rates are very low for savings accounts. We’ll be very pessimistic and assume you won’t earn any interest on the money. How much do you need to put aside each month? Easy. $100.

You have to admit that it’s far easier to deposit $100 each month into your sinking fund than to come up with $1200 a year from now all at one time. Am I right?

This is a pretty straight forward concept you learned as a child when your mom told you that you would have to save up first if you wanted to go to the roller rink. But somewhere along the credit card highway, we forgot those all important lessons mom taught us. That’s why people buy stuff they can’t afford and end up frantically trying to get out of credit card debt.

Before you make a purchase, ask yourself if you can afford the sinking fund you’ll have to set up in order to replace the asset. If not, I strongly encourage you to find a less expensive solution or delay your purchase until you know how you’re going to replace it.

Do you use sinking funds to pre-fund asset purchases? Why or why not? How do you come up with the money to replace assets once they’ve worn out?

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{ 1 comment… read it below or add one }

Ronald R. Dodge, Jr. January 4, 2013 at 7:44 AM

What you describe as the sinking fund dealing with long-term assets, I just think of as part of the emergency fund plan. While many people including Dave Ramsey claims to separate out your funds for the various expenses, I refuse to actually do that for the simple reason, the more your divide up your money, the less your money can work for you. Think about it. There could be cases of tiered interest payments, or it could be the case you can’t do as much with your money physically divided from each other vs if you have your funds all grouped together, the incoming cash from the various sources can allow you to do more investing.

What are the three components of my emergency fund?

First component is the part dealing with replacing/repairing long-term assets (Hence, your sinking fund portion). Again, I use depreciation to indicate how much money that needs to go into this part of the emergency fund. Given all of the other things that one must do, and have rarely ever made money above poverty level for our household size, this has been no easy accomplishment to do. On the other hand, regardless of how much I have put in, even though it’s been well short of the suggested amount per the depreciation calculations, I still been able to get things repaired/replaced as needed. Yes, I use a credit card in many cases, but not so much because of being short of money, but rather more so because it would cost me the same rather if I use the CC or cash, and I get cash back using the credit card along with earning more interest on the cash. Not only that, but the CC also buys me additional time to be able to get the money from the emergency fund as I don’t apply to the suggestion of just putting that money into a low interest bearing savings account as people like Dave Ramsey says to do. The reason why I don’t abscribe to that, it is an automatic losing battle to the risk of inflation. If you think about it, the biggest part of the emergency fund is dealing with long-term assets and other long-term aspects of life, so why do you want to tie up all of that money in short-term investments that does you little. I can see keeping a small amount of it in short-term investments, but only a very small amount of it.

Component 2 deals with the fact things happen. You may get defective products or products that wears out faster than you expected. Your assets may get damaged by external forces. For this example, all you have to do is look at what happened in the Northern KY area on March 2nd, 2012, when those 2 tornadoes (1 more or less right behind the other) came through and destroyed a lot of places. They were rated as EF4 tornadoes. That’s just one example. Another thing, what if something happens to your health or another person’s health who live within the household and you need to shell out a significant amount of money to cover for that. Example, what if your child get a broken bone from partaking in sports or something else?

I take these things into account along with what’s in the first component of the emergency fund, and I look at, what is needed between these 2 components to be in the emergency funds. These 2 components in many respects are very related for the portion dealing with long-term assets, but the health part is a definite add on.

Before I go onto the third and final component of the emergency fund, as it deals with a completely different type of emergency (One of which I am currently in), I look at the results of these first two components combined. For our particular household with our set of circumstances, I have determined, we need to have an emergency fund of about $250,000. Obviously, this is no easy goal to reach, and there are things that must be done to get to that point.

Now onto the third and final component of the emergency fund. What would you do if you lost your job, or your income was significantly reduced? How much money do you need to have to cover your expenses while you are on unemployment? How long can you expect to be on unemployment?

First, as my professor mentioned in our Profession Ethics in Accounting class, one need to put money into savings for when one may have to quit a job for ethical reasons (And yes, there has been cases like that such as Enron, WorldCom, Tyco, and so on). If you quit a job, you won’t get unemployment. To answer the question of how much money to put into the emergency fund for such a case, you need to basically answer 2 questions.

Question 1: What is your average monthly cash flow demands? For our household, that works out to be about $3,500 (Of late, it’s been more, but that’s only because of the higher education expenses. If you exclude the higher education expenses, then it is about $3,500)

Question 2: How much money do you expect to be making? One thing that was mentioned in the class, and supposedly, it is the case, what ever annual amount of money you expect to be making, divide that by $10,000 and that determines roughly how many months you will be on unemployment. In my case, obviously that math didn’t work out, but I suspected it is also because I didn’t have the paper work to backup my work experience or knowledge. If you really want to keep it simple and realistic, you might as well assume it will be 1 year of unemployment.

That means, for a total cash flow demand, our household would need an amount of $42,000 ($3,500 * 12 months). Now add this to the already $25o,o00, and that takes the needed amount up to $292,000.

The only things you could possibly do to help knock this amount back down are to ask yourself the following questions:

Do you expect to get help from other sources? (Given the set of circumstances I faced, I answered “Yes”, and that has come through. As such, that $14,000 emergency fund I had built up so far have sustained us for the 19 months I have been on unemployment with just $3,000 taken from it, which was specifically used to replace the transmission on the Saturn from an incident that destroyed the previous transmission and I’m having to seek damages from the city as it was the road that damaged the transmission. I know that sounds fishy, but if you look at how the sudden grade change takes place (From leveled to 45 degree incline at one point) at the intersection where the damage happened, you could see why that damage happened along with the fact the car sits low to the ground). I was driving at 10MPH when that happened. Anymore when I come to any location with sudden grade changes, it has me backing off, even if the grade change is curved off.

Given what you have in the emergency fund and what sources of income it gets, how much of those income sources can be used to offset the need for some of these things such as the unemployment situation?

Take this exercise, and to make it relatively easy to remember, I just round that number up to $300,000 for the emergency fund. As for retirement, I look at that as needing to be a multiple of 50 of what I need for annual income net of taxes. For that, I figured, I need to have a retirement fund of $4.5 million net of income taxes. Add that to the 0.3 million energency fund, that makes it at a total of $4.8 million, or might as well say a total of $5.0 million of total investable assets net of income taxes. My funds are currently only about 2% of the way there, which took 10 years to get that.

To get to that $5.0 million, I determined one must put 25% of actual gross earned income to countable savings, and I will leave it at that given it requires a strategy, but this article is not about that.

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