What is a Sinking Fund and Why Do You Need One?

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Article by: Money254

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This article originally appeared on Money254. Money254 helps consumers and business owners to search, compare and apply for financial products in Kenya.

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Photo by Josh Appel on Unsplash

Every person aspiring to grow has life goals they should meet within a specific period. 
The financial targets you set for these goals could be more extensive and dent your monthly budget.

You need tools such as a budget which can help with daily spending, emergency funds to protect against unexpected expenses, and savings or investment accounts that significantly improve your finances.

Some predictable expenses could make a hefty dent in your budget. To finance this kind of goal, you need a sinking fund.

In this article, you will learn about a sinking fund and why you need one to meet your financial goals.

What is a sinking fund?

A sinking fund refers to the amount of money set aside for a specific, planned purpose within a period of time. It is savings involving clear set goals to be met for a set period like buying a car, a home, school fees, furniture, vacation, wedding and gifts.

Sinking funds are significant for meeting your financial targets without facing any financial constraints. For instance, if you have a sinking fund for school fees, you will not need to cut your monthly budget or borrow money.

Sinking funds are also useful for companies in terms of paying debt or bonds. The business sets aside some amount from its revenue for the period before the bond matures. This helps them soften hardships during debt payment.

Examples of sinking fund
The fund can be used for any purpose, specifically for expenses that would break your budget if you were to purchase randomly.

Examples of sinking funds include savings for home repairs, vacation, gifts, buying a new car or repairing the old one, planned medical expenses, tuition or school fees, charitable giving and taxes.

You could also take insurance premiums, buy new furniture or save for big events, like weddings, baby showers and come-together parties.

Steps to set up sinking fund

Just like any other saving, a sinking fund requires planning and setting up targets to meet your goals. A successful sinking fund would require you to:

1.  Set up your saving goal and target

The first step you should take is knowing what you want to do. This is your goal and should be short-term. For example, if you plan on repairing a car or buying a new one. You cannot afford this on your monthly budget. You need to save it for a specific period in a high-interest savings account.

Set up the target. Perhaps you have a set goal, which is to buy a new car. Now, you will need to know which kind of car it is and how much it costs. This will give you the rough amount you need, for instance, a car that goes for KSh 1.2 million. This will become your target amount to save towards.

But some sinking fund expenses like repairs and maintenance will not give you a clear amount that you need to save. To set a target for this kind of expense, you need to review the prevailing market conditions and your previous expenses on the same. If you have spent KSh 50,000 on car repairs in the past, you could consider raising that amount in the future sinking fund accounts.

2.  Set a timeline
The time frame you pick to set aside sinking funds is significant in achieving your goals. For instance, your target is to raise KSh 1.2 million to buy a new car. What timeline do you think will be feasible to meet that target?

Setting up a timeline would depend on your income. Whether you are working, self-employed or doing business, you could set up a timeline that will not put a strain on your monthly budget. For instance, you could plan your sinking fund for a new car to end within two years. That means you will need to save KSh 50,000 per month.

Financial experts advise that for expenses like maintenance and repair, the timeline should not be fixed, because they could come earlier than expected.

3.  Include it in your budget
A budget is a guide plan on how you are spending your revenue. Monthly budgets are significant in your financial growth and development. They define your spending on savings, investments and expenditures.

Your sinking fund is a kind of saving that should fit into this budget, so as to avoid extraneous spending. Your goal, target and timeline to hit should be fixed into your monthly budget. This will give you an overview of where the fund will come from, and which expenses can be cut to facilitate the sinking fund.

A budget also helps you determine the amount you will put aside in the sinking fund account. It opens avenues to raising the fund like identifying new income sources including taking up side hustles or part-time jobs.

Sinking fund account

Sinking funds are not equal and have different priorities. For instance, a sinking fund for the Christmas holiday will not be equal to saving for a home.

Different banks offer different savings accounts that you could choose to have your sinking fund stashed for a specific period. However, it is advised that you set your sinking fund in savings accounts that do not have minimum balances. For example, if a savings account requires a minimum amount of KSh 50,000 to operate, yet you have a monthly sinking fund target of KSh 30,000, you will not be able to save.

Setting up a sinking fund account requires financial discipline. The best account to choose for a sinking fund is a locked savings account. This will not give you any temptation to pull from it until it is time to implement the idea.

Sinking fund vs savings, emergency fund

Although they fall in the same category, sinking funds defer a great deal from savings and emergency funds. The fund is more specific, targeted and expected to happen.

Savings are significant for long-term needs and goals that do not need a specific timeline. They involve stashing away money for some time to help meet a future expense you are not certain about. But sinking funds involve meeting a targeted and expected short-term financial goal like purchasing furniture.

Emergency funds are set aside for unexpected expenses like loss of employment if you are employed or collapse of businesses, illness and natural happenings. This fund needs to be rebuilt as quickly as possible once you have used it.

The sinking fund operates in a different manner as it involves one-time goals or expenses. Once you are done with your holiday, gifting or wedding, you do not need to start rebuilding the fund immediately.

Why do you need a sinking fund?

Stabilise your finances
Financial stability refers to when you are able to meet all your needs, goals and expectations. It is a journey that involves planning and budgeting to meet your set goals.

A sinking fund is significant in building your financial stability as it strengthens the course. For instance, say you have a savings account and emergency fund alone and you want to go on a vacation with your family.

Dipping your hands into either of these accounts compromises your financial growth. This is where a sinking fund gives you financial discipline. With it, you plan for your holiday, give it a timeline and fix it in your budget so that you cannot spend on your emergency fund.

Build wealth
Building wealth refers to a long-term process of stabilising your financial status. This could be achieved through financial planning, setting up your goals, and targets, creating and increasing your sources of income and tracking your financial progress.

A sinking fund is relevant in the wealth creation process. The goals you meet while running a sinking fund account add value to your wealth. For instance, if you buy a home, repair or maintain one, you are appreciating your wealth value.

The process of wealth creation does not thrive when your monthly budget is weak or going through constraints like paying debts. A sinking fund will always make sure that your income is not strained when it comes to expected expenses like welcoming a new member of the family, joining a school or attending a family party.

Improves credit worth
Creditworthiness is determined by your credit ratings; whether positive or negative. It involves your ability to repay loans.

A sinking fund could rate your creditworthiness positively, thus improving your chances of qualifying for loans. For instance, if a lender learns that you have a sinking fund for buying a home and you need a mortgage loan, you will qualify for the loan without any compromise because the fund is security.

It also improves the possibility of lower interest rates for loans. With a sinking fund, the interest rate for a car loan may be more favourable and affordable because the fund provides protection.

Wrapping up

Sinking funds are simply proactive plans that you set to keep your financial growth journey on track. When you set up a comprehensive financial plan, you ought to include measures that will limit stress and disruptions from big expenses.

These kinds of expenses are infrequent and can dig a deep hole into your budget, thus hurting your income and financial growth. Yet you could avoid them if you include them in your budget since they are expected and specified.

A Sinking fund is vital as it simplifies your monthly budget and keeps your financial goals separate.  This is one of the best ways to keep your wealth creation process on course.