A sinking fund strategy is popular in the corporate world for paying off bonds or debt.
But you can use the same strategy for your personal finances to help you pay for irregular expenses as well as save for short-term goals and long-term goals.
In this post, I’ll walk you through the pros and cons of sinking funds so you can determine if they will help you reach your financial goals.
Here’s a hint. If you are disciplined, there is really no reason not to use this strategy to save money.
10 Important Pros And Cons Of Sinking Funds
5 Pros Of Sinking Funds
Here are the biggest advantages of sinking funds you can expect to experience by implementing them in your finances.
#1. Save For Irregular Expenses
The biggest benefit of sinking funds is to help you pay for irregular expenses.
Regardless if you have a monthly budget or not, you know the surprise bills you get are never pleasant.
For many of us, this includes your annual life insurance premium, auto insurance premiums, sewer bills, car repair, and more.
Basically, irregular expenses are anything that you don’t have to pay monthly.
Because of this, most people forget about these unexpected expenses and then have to raid their emergency savings or go into debt to pay the bill.
By creating a savings account and putting money into the account on a regular basis, you never will be surprised by these bills again.
Simply take the annual amount you owe and divide it by 12. Then save this amount of money every month.
For example, if your bill is for $1,200 then you save $100.
To make the sinking fund method work best, you should create a separate account for each bill so you know where you stand at any given time.
Also you should set up automatic transfers from your checking account to your savings account so you never have to remember to set aside money every month.
#2. Save For Large Purchases Or Build An Emergency Fund
Using sinking funds isn’t just for irregular expenses.
You can use this strategy to cover large expenses too.
The process is virtually the same.
You create a separate savings account for a specific goal, in this case we will say for a new car, and then set up a monthly transfer amount.
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The trickiest part is knowing how much to save.
If you know when you will need the money, you just divide the amount you need by the number of months until you need it.
So if you plan on taking a big vacation in 5 years and you need $5,000 you would divide $5,000 by 60 months to get $83.33.
You can create multiple savings accounts for each goal too.
Between saving for irregular expenses and long term savings goals, I have close to 20 different savings accounts.
#3. Avoid Going Into Debt
I touched on this before, but another positive to sinking funds is you avoid debt.
Many times people don’t have the money saved to pay for irregular expenses.
And they don’t save the entire amount they need for vacations or other goals either.
They end up putting the expense on their credit card and then working to get out of credit card debt.
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The problem with this is you put yourself in a bad financial situation.
If you lose your job or something comes up, you are going to get yourself into even more debt, stressing you and your finances out more.
Also, you will be paying interest on this debt, making whatever you purchased that much more costly.
The interest charges will also make it harder to get out of debt.
By having money saved, you can avoid this debt trap and be less stressed about money.
#4. Earn Interest On Your Savings
When you save money, you earn interest.
And if you use an online bank, you are going to earn a higher interest rate than you would earn at a traditional bank or credit union.
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This means you need to save less money because the interest you earn can be put towards your expenses and savings goals as well.
If you are saving a lot of money for a big trip or other goal, the interest you earn could be substantial.
#5. Avoid Impulse Purchases
When you embrace the idea of sinking funds, you are less likely to give in to impulse purchases.
Instead, you will know that you need to set up a savings plan to be able to afford the item that you want.
And in some cases, you will realize during the setup process that you don’t really want the item that you thought you did.
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The end result is you have more money for other things in life as you are spending less haphazardly.
You also lower the risk of going into credit card debt as you are more conscious of your spending.
5 Cons Of A Sinking Fund
As great as the benefits that I’ve discussed are, there are drawbacks to sinking funds.
Here are the ones you need to take into account if you want to be successful.
#1. Might Spend Money Elsewhere
You might find that you set up accounts for future expenses, but that you get tempted and give into that temptation to spend the money elsewhere.
This is directly the opposite of avoiding impulse buys as I mentioned earlier.
For example, you might be saving money for a vacation but then see that flat screen TVs are on sale and spend the money you saved on this item.
The problem here is that now you need to save even more money if you want to reach your goal.
If you need $5,000 for a trip in 5 years, you need to save roughly $83 a month.
But if you spend the money you saved on a TV and now only have 3 years to save for the trip, you have to now save $139 a month.
This could be a deal breaker if money is tight.
#2. Not Disciplined
One of the biggest drawbacks to sinking funds isn’t the strategy itself, it’s that you aren’t disciplined enough to see the process through.
You might miss funding your accounts if you don’t have automatic transfers set up, or you might fall victim to impulse buys as I mentioned above.
This is why I tend to have my accounts at different banks.
Having to log into another bank, as simple as it is, discourages me from making the attempt to sabotage myself.
#3. Give Up From Small Progress
Related to not being disciplined is giving up because it doesn’t look like you are making any progress.
If you are saving $83 a month for a $5,000 vacation, after three months you only have $249 saved.
I say only because many people will overlook that they are actually saving money and instead will focus on the fact they are so far away from their goal.
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The result is some will give up, thinking it isn’t worth the small effort.
But if you can see it through, you will reach your goals, guaranteed.
The trick I like to use is not log into my account to check my balances very often.
Then when I do log in, I am surprised at how much money I actually have been able to save.
#4. Spread Yourself Thin
Another potential roadblock is spreading yourself too thin.
This could be an issue if money is tight and you don’t have a lot of cash to save every month.
Or you might get too excited about this strategy and create so many different goals, that you can’t fund them all and get frustrated and give up.
Because of this, I recommend you start small.
Begin with saving for all your irregular expenses and one or two savings goals.
Stick with this plan for 6 months and then re-assess.
If you are doing OK and have the ability to save more money, then you can consider adding another savings goal into the mix.
Then you can re-assess in another 6 months and repeat the process.
#5. Gets Complicated
The final con of sinking funds is the process can get complicated.
Setting up accounts and transfers is not complicated.
But it can get complicated if you have 30 separate accounts you are trying to fund.
You can run into possible issues by overdrawing your account because so much money is coming out.
Another issue is when you look at your account transactions.
You will see a ton of transfers to each of your saving accounts.
This can be confusing as most banks will only show the last four digits of your account number.
While this isn’t as big of a deal as overdrawing your account, it is something to take into account.
At the end of the day, these are the biggest pros and cons of sinking funds.
In the beginning of this post, I mentioned that this strategy is great for everyone to use and I stand by that.
The only issue most people will face is being disciplined to see it through.
You might be tempted to stop saving along the way or spend the money elsewhere.
If you can get past this issue, then you will see a positive transformation to your finances and will reach your financial goals.