As you know, our money strategy is to follow Dave Ramsey’s baby steps, and in my recent post explaining Baby Step 3, I mentioned “sinking funds.” It’s a simple financial strategy, and it’s not new, but it has enormously helped our family’s finances. And I encourage you to start using sinking funds even while paying off debt via the debt snowball.
Photo by Ironic Tonic
Simply put, sinking funds are a reserve of money set aside for some purpose. It’s a commonly used business and government practice, and it should be part of a healthy personal budget as well. If you think of your family as a company that you’ve been assigned to manage, it would only make sense to make sure you have funds readily available for the many things that surface on any given year.
Think of all those non-monthly payments or purchases you face on a regular basis. For some people, auto insurance shows up once or twice a year. What about new school clothes for your kiddos? These aren’t things you spend money on each month, but you still need to pay for them when they show up.
Nothing can screw up a debt-free plan quite like these irregular expenses. In fact, I’ll bet that’s how many people find themselves in debt.
“What? Christmas is only three weeks away? There’s no money in the budget – I guess we’ll have to whip out the Master Card.”
“Why oh why did our insurance bill arrive just when we had to pay for Sally’s recital costume? Looks like it’s Visa to the rescue again.”
If you know these irregular expenses are headed your way, it would only make sense to set aside a small portion of each budget towards them. This, in a nutshell, is sinking funds.
Christmas is an easy example. Let’s say you calculate a need of $500 for your Christmas holiday (gifts, decorations, cards, extra food – the whole shebang). It’s now March 7, about nine months away until the next season. If you didn’t start saving for Christmas 08 in January 08, that means you have nine months to complete your Christmas 08 fund – and 500 divided by 9 is $55.56. That’s how much you should list in “Christmas” as part of your regular, monthly budget.
(A side note: some people prefer to budget according to their paycheck, not just by the month. If this is you, and if you get paid biweekly, then you’ll calculate how many paychecks you anticipate from now until Christmas, and divide into that number, not the months.)
Sinking funds is an easy enough concept. But like many things in life, it’s one thing to use this method on paper; it’s quite another to put your money where your… idea… is. Sinking funds can get really fuzzy and confusing when they’re all lumped together in one savings account. Even when you keep detailed monthly records of what dollar is assigned to what, all this can rapidly become overwhelming. At least it did for me.
That’s why sinking funds didn’t work for us… until recently. Thanks to Capital One 360, we can open as many savings accounts as we want, and it doesn’t cost us a dime. We can even customize each account with a different name, and we can seamlessly automate transfers from our checking account to our various savings accounts.
We currently have five savings accounts, respectively named “Emergency Fund,” “Giving,” “Holidays & Gifts,” “Vacation,” and “Work Expenses.” Each month when our paycheck arrives, we have Capital One 360 automatically transfer a set amount from our checking account into each of these accounts. Most of the money stays parked in these accounts for months at a time, until expenses arise that fit these categories.
When we need funds for these categories, we simply transfer the needed amount back into our checking account and use the amount for that expense. Very easy.
I should mention that during debt elimination, the type of sinking funds you have should be limited to the necessities. For the most part, you don’t need to focus on a family vacation or a new couch when your overarching financial goal is debt freedom. So limit sinking funds for things like quarterly and annual bills and necessities. When you’re debt-free, then you can start saving for the extra stuff.
And like I said, I think sinking funds are crucial especially during a season of debt reduction. The last thing you want to do is accrue more debt. With a Baby Emergency Fund of $1,000 and some basic sinking funds in place, it becomes so much easier to know exactly how much you can pile on your debt snowball.