Why Do We Need a Sinking Fund? How to Establish a Sinking Fund and the Various Options Available

Why Do We Need a Sinking Fund? How to Establish a Sinking Fund and the Various Options Available

Traditionally, businesses have used a “sinking fund” to put money away on a regular basis in order to retire a bond or repay a debt. If the company establishes a sinking fund, it will have a smaller out-of-pocket payment when the loan matures. However, the same method can be used by people to put money aside for unforeseen costs or large purchases without resorting to utilising credit or draining an emergency fund. Individuals, not just businesses, can benefit from the time-tested saving method of sinking funds.

However, what is a “sinking fund,” exactly?

To prepare for a specific cost that you know will arise in the future; you can set aside money in a “sinking fund.” It is not the same as a savings account or an emergency savings account, which can help you put money aside for things like replacing a broken water heater. Calculating how much money will be needed to cover an upcoming purchase and setting aside a fixed amount of money each month can be thought of as creating a sinking fund.

Real-world application of a sinking fund example

Let’s say you’re planning on spending about $1,200 on a trip sometime next year. A sinking fund can be used as an alternative to paying for large, unexpected bills using savings or utilising credit cards to finance a vacation. Every month, you’ll put $100 more into the sinking fund. You won’t have to worry too much about your budget if you save up $1,200 by the end of the year to cover the cost of your vacation.

The Sinking Fund Contains Several Types of Accounts

If you think using a sinking fund is a good strategy, the first step is to figure out where to put the money. Below are some examples of potential sinking fund savings accounts.

Checkbook-balanced account

A free checking account is an excellent choice for a sinking fund because the funds are easily accessible at any time. Consider creating a second checking account to put money aside that is earmarked just for that one large purchase if you are going to make one soon. Consider switching checking accounts to one that offers a better interest rate if you’re hoping to maximise your savings.

Conventional savings accounts

You can also use a regular savings account to save for a sinking fund. If you currently have an account with a bank or credit union, opening a new savings account there will make transferring money between the accounts easy. However, standard savings accounts typically do not provide attractive interest rates; so, if you’re hoping to earn a profit on your investment, this may not be the best route to take.

A HYSA is a high-yield savings account

The interest you earn from a high-yield savings account is higher since its annual percentage yield (APR) is larger than that of a regular savings account. Establishing a high-yield savings account (HYSA) as a sinking fund will help you save more money over time and potentially reach your goal sooner. Because of their lower operating expenses, internet banks are sometimes able to provide larger yearly percentage rates on high yield savings accounts (HYSAs) than their brick-and-mortar counterparts.

Sinking funds, when used correctly, can be a useful budgeting tool

While certain costs can’t be predicted, those that can make it much easier to set aside money to cover them. A sinking fund is a form of budgeting that allows you to set aside money in preparation for specific, foreseeable expenses. Having a sinking fund means you can avoid using your credit card or your emergency savings to pay for unexpected costs. Rather of turning to either of these options, you can simply save enough for it over time and pay for it outright.