Whether you use a budget or not, I bet you can name several significant expenses that you know you’re going to be paying in the next six to twelve months.
How about Christmas? Maybe the car needs tires or the roof needs to be re-shingled. How about that auto insurance payment you make every six months?
Even though you know they are coming, you often end up using your credit card to pay for these items. Now, you”re not only paying for the expense, but you’re paying interest too!
So, I hear you saying, what the heck is a sinking fund, and how can it reduce my debt? A sinking fund is basically the opposite of a credit card. In simple terms, a sinking fund is when you save a set amount of money each month, over a period of time, to pay for a future purchase or expense.
How does a sinking fund approach work?
Let’s say you know that you will spend around $1,000 on Christmas, and we’re in March.
Take the $1,000 and divide by nine months (March through November). Set aside $110 each month. Then, come December, you will have $990 saved, specifically for this purpose.
You can even use the sinking fund approach for small expenses.
If you know that you are going to be buying a birthday or graduation gift, you can set aside a small amount each month leading up to the event.
Some people use envelopes to hold the money. Just don’t be tempted to dip into that envelope to go see a movie or when that girl scout comes to your door selling cookies.
Also, be careful keeping money in your house. If the amount is going to be significant at all, a bank account is a safer place to keep it.
You can also use the sinking fund method for discretionary purchases.
In fact, the method works even better for this type of purchase since you have control over when you make the purchase.
If you really want that new big screen television, set aside some money each month until you save up the purchase price instead of using your credit card.
You may already be putting money into your savings account every month for “unexpected expenses.” Isn”t that the same thing? Well, no.
You still need your “emergency fund” for those truly unexpected expenses. A sinking fund is for an expense that you know is coming.
You can use the same saving account for both as long as you are disciplined about knowing how much is “emergency” money and how much is “sinking fund” money. If you decide to use a separate savings or checking account for your sinking fund, just be sure the bank fees don’t eat up your money.
The well-known radio personality and financial author, Dave Ramsey, wrote a recent blog post about this sinking fund approach (see Stop the Panic with a Sinking Fund).
He points out that although the concept is pretty simple, not many people use it. The reason is that it takes a skill that not many people have mastered, namely patience. He notes that we live in a culture where we buy now and bring an item home today.
He also points out that the credit card companies and banks are counting on people not planning ahead so they can collect those interest charges and fees.
Even if you only use the “sinking fund” approach for one or two of your larger expenses that are coming up within the next year, you may significantly lower your debt by not having to charge them. Keeping large purchases off of your credit card can really help you get your debt under control.
Joel Fink is a retired CPA and financial services executive living in Dallas, Texas. He enjoys writing articles that help real people with simple ideas to manage their money and improve their lives.