What is a sinking fund and how can it keep your budget on track?

The savings strategy covers large, expected expenses you are likely to incur over a 12-month period

Always overestimate the amount you need for a sinking fund to provide a buffer in case one of your expenses is larger than planned. Getty Images

When you hear the word “budget”, what is the first thing that comes to mind?

For many, a budget could mean categorising expenses such as groceries, rent, bills and clothing, as well as tracking monthly spending and living within your means. It seems simple, so why do so many people struggle to stick to a budget?

One of the reasons is a lack of planning for larger expenses. Despite putting money aside for a few months, many people find themselves dipping into their savings to cover expenses such as school fees, car insurance, flights, housemaid visas or their rent.

This is where a sinking fund can help to keep your budget afloat and minimise your financial stress by spreading the cost of expenses throughout the year.

Sinking funds are used to cover large, expected expenses that you are likely to incur over a 12-month period. They are different from daily and monthly expenses, such as your electricity bill or pet food. These expenses are typically large and would not be covered by your monthly income.

They also tend not to occur every month and can, therefore, be overlooked when people track expenses and estimate how much they spend.

If you aren’t paying close attention to your finances, these expenditures can derail you and even land you in debt.

They also differ slightly from savings goals, which are usually used to pay for one-off items – think luxury holidays, a new car, a house deposit or a big wedding – that may take a year or more to save up for.

A sinking fund, on the other hand, covers recurring, necessary bills or annual celebrations, such as Eid or Christmas, annual car service and insurance, medical payments, school fees or house maintenance, to name just a few.

Once you set aside money in your sinking fund, it is there for you to use for future payments and fees. The use of sinking funds is a method in which you give your current money a future purpose to be spent – and eases the pain of paying a large bill all at once.

It is important to note that the aim of a sinking fund is different from an emergency fund. An emergency fund is money set aside for the purpose of unexpected financial crises, such as a medical emergency, a job loss or unplanned car repairs.

It is usually a static number equal to three to six months of your expenses. Generally, this pot of money is kept separate from the sinking fund.

How do sinking funds work? The first step is to plan ahead. Use a calendar or talk to your family to work out all the large expenses you will probably incur in the coming year. For each expense, evaluate whether it will be paid from your monthly budget or your sinking fund.

Once you’ve calculated an estimate of all expected expenses in the year ahead, add them together and divide by 12. This is the monthly total that you transfer to your sinking fund account to stay on top of your expenses.

It is helpful to open a sub-account to your current bank account or a new savings account to keep your sinking fund separate from your daily expenses.

Sinking funds are used to cover large, expected expenses that you are likely to incur over a 12-month period

Alison Soltani,
ounder of LeapSavvySavers.com

I would overestimate the amount you need for a sinking fund to provide a buffer in case one of your expenses is larger than planned.

Some people choose to factor in all expenses in a single sinking fund account, while others prefer to open a different account for each item.

This could be, for instance, separate accounts for travel, gifts and festivals, among others. This is up to you, but generally the fewer sinking fund items you have, the easier it will be to manage your expenses.

Sinking funds offer many benefits, including peace of mind because you are covered for upcoming expenses. They also help you to save and invest regularly because your larger expenses are spread across the year.

Sinking funds also add a layer of financial armour to your budget and help to keep your finances afloat – and your money goals on track.

Alison Soltani is the founder of LeapSavvySavers.com