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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