When it comes to your family’s finances, you already know you need an emergency fund to protect you from a job layoff or major medical illness. But what about all of those little expenses that come up year after year, like car insurance, Christmas, or your annual family vacation?

That’s what sinking funds are for, and they’re the secret to a successful budget.

When money is tight, or you’re working on a big debt-payoff goal, covering all of your expenses is key to making it work. With sinking funds, you can easily stick to your budget even when faced with costs that don’t come up that often. Here’s how to get started.

What is a Sinking Fund?

A sinking fund is a fancy word for saving money that’s separate from your checking or emergency fund. Have you ever saved up to buy something? Then you’ve already used a sinking fund!

Sinking funds are meant to help you save for planned expenses. When you know there’s something coming up that you’ll need extra money for, you can save a little bit each month. That way, you’ll have the cash available when you need it, and you won’t have to rely on a credit card or borrowing from your emergency fund.

Whether you’re saving to pay for Christmas gifts or an insurance premium, you can use a sinking fund anytime you want to set aside money regularly to pay for something in the future.

Sinking Funds vs. Emergency Fund

Emergency funds are an essential part of living financially free, and they help protect your family from unplanned and unknown events. But too often, it’s the little expenses that pop up and derail your best budgeting efforts, and that’s how sinking funds can help. Here's a bit of the difference:

Sinking Funds:

• Save for planned expenses
• Add a little money each week
• Kept in a separate account
• Can have more than one

Emergency Funds:

• Money saved for true emergencies
• Kept in a separate account
• Used for needs, not “wants”

In short, we're looking at the long-term “known costs” (sinking funds) versus the short-term “unknown costs” (emergency funds). Utilizing that way of thinking can help you plan accordingly.

Where to Keep Your Sinking Fund

When it comes to saving money, you can keep your sinking fund in a bank account or add money to a cash envelope. As long as you’re adding a little cash to them every month, it doesn’t matter so much where you stash your money.

Cash Envelopes

Using a cash envelope is a simple way to save, and you can take the money out when you’re ready to use it. The downside of having it so easily accessible is the temptation to spend it. When you know the money is there, it can be hard to resist dipping into it for take-out on a busy weeknight.

Bank Accounts

With the popularity of direct deposit and budgeting apps, it might be easier if you keep your sinking funds in a bank account. Separating your sinking funds from your other accounts is sure to keep you from spending it on something other than your goal.

The quickest solution is to set up a savings account to keep your cash, and you can open one at the same bank you’re already using. But setting up an account at a different bank, such as an online bank or the one on the other side of town, can help if you’re worried about feeling tempted to spend the money.

Whether you set up one account for all your savings goals or have a separate account for each sinking fund is entirely up to you. It’s easier to keep a separate account for each one because then you can see at a glance how much you’re saving toward each area.

But if you combine all of your funds into a single account, you can use a pen and paper or set up a spreadsheet to make sure you’re keeping track of how much you have saved toward your goals.

What Sinking Funds Do You Need?

Figuring out what sinking funds you need is different for everyone. For instance, if you have young kids at home, it makes sense to save for preschool, daycare or summer camp. Here are some other ideas of sinking funds you might want to set up.

Car Fund

New tires for the car aren’t cheap, and setting aside money every month will help cover the cost. You can also save for auto insurance premiums, oil changes, registration fees, and parking or speeding tickets.

Water Bill

When you have bills that aren’t due every month, using a sinking fund to save for them will help keep your budget in check. Otherwise, you’re left sacrificing another category to free up the funds to pay for bills like your water, sewer, or trash and recycling service.

House Repairs

Depending on your goals, your house repair fund can be big or small. If you’re planning to add a deck, replace the siding, or landscape the yard, you’ll need more money than if you’re saving to pay for the occasional plumber to unclog the kitchen sink.

Clothes

It’s unlikely that you buy clothes every month, but sometimes you (or the kids) need new clothes. Saving up a little at a time is an excellent way to update your wardrobe without breaking the bank.

Medical Expenses

Even the best insurance plans have deductibles and co-pays. Sometimes, you’ll have regular prescription co-pays you can include in your budget every month, but a sinking fund is for everything else.

Birthdays and Christmas

A dollar doesn’t go as far as it used to and buying gifts can throw your budget way off track. But if you save a little each month to pay for Christmas gifts and birthday presents, you’ll have the money when you need it.

Vacations

Whether it’s spring break, an anniversary trip, or your dream vacation to Paris, having a vacation fund can turn your dream into a reality without going into debt.

Why Your Budget Needs Sinking Funds

A lot of people think you can accomplish all your financial goals with an emergency fund. While having money set aside for real emergencies is a significant part of your financial plan, having sinking funds in place is just as important.

Example #1: Christmas

The best example of why your budget needs a sinking fund is Christmas. You know it's every year in December, yet there’s always some expenses that end up on your credit card. Instead of dreading the bill that comes in January, you can plan for it with a Christmas fund.

To do that, you’ll need an idea of what you typically spend each Christmas. Add up what you spend on gifts, extra food for all the Christmas parties, decorations, and additional charitable donations to see how much you’ll need. Then, divide that number by the number of months between now and when you’ll start your Christmas shopping.

If you tend to spend $1,500 each Christmas, that’s your savings goal. And if it’s already June and you want to start buying gifts in November, that gives you five months to save. That’s $300 each month you’ll have to put in your Christmas fund to have enough money set aside when you need it. Depending on your monthly budget, you may not have an extra $300 to save. In that case, you’ll need to adjust your spending or find a way to increase your income to have enough money.

Example #2: Vacation

The same is true for your family’s annual vacation.

To take your family on a beach vacation, it’ll cost around $2,000. If you start planning a year in advance, you’ll only have to save $167 each month to pay cash for the whole thing.

Final Thoughts on Sinking Funds

You already know you need to plan for upcoming events and set aside a little extra for unexpected costs. Having a budget and an emergency fund is important when it comes to living financially free. But sinking funds help you prepare in advance for regular living expenses to keep your spending on track and protect your emergency savings.

By looking ahead, you can use sinking funds to set aside the money you need for Christmas, your water bill, family vacations, and car insurance premiums. That way, you’ll have the money you need when you need it, so you don’t blow your budget or go further into debt by using your credit card.

Do you use sinking funds? Which one has saved you the most?

Please let us know in the comments below!