How Do Sinking Funds Work?

Whether you're paying off debt, or are planning ahead for a specific large purchase, knowing the ins and outs of a sinking fund can be financially beneficial. For starters, sinking funds function as a kind of earmarked savings account. Money placed into this kind of fund is specifically intended to either pay for a future purchase or pay off a particular debt and/or bond. This can be an especially important financial tool when you consider that American consumers currently owe a whopping $17.69 trillion in household debt, according to the Federal Reserve Bank of New York. However, more concerning is that 9% of all credit card balances and 8% of auto loans became delinquent in the first quarter of 2024.

While you might be asking yourself how a sinking fund is different from, say, an emergency fund (here's how much money you should save in one of those types of accounts), the key thing to keep in mind about sinking funds is that they have a very specific purpose and/or ultimate destination (unlike emergency funds that serve as general reserves in case of an unnamed emergency). Further, when it comes to sinking funds, it's more about how you save your money as opposed to where you save it. Rather than thinking of a specific account type (i.e., savings) in which to store money, sinking funds are more rooted in planning for something specific in the future. This means there's no limit to the amount of sinking funds you might choose to maintain (although remember not to over-prioritize future savings over present expenses).

When it comes to saving money, it can be easy to lose track of what's actually meant to go where. This is one of the major ways sinking funds can help with your personal finances (and in particular, budgeting). Since it can be easy to mix up different savings goals, especially if all of your savings share one account, a sinking fund allows you to create a more organized savings strategy dedicated to specific planned purchases. Plus, by better tracking your goals, it can help you avoid any potential interest and/or late fees on those future purchases. Whereas you might have had to use a credit card or a payment plan (there are some serious downsides to buy-now-pay-later services) in the past, a plan-ahead sinking fund can ensure you avoid the hassles of pay-back options.

Also, if you're using sinking funds specifically to pay off a debt or bond, there can be some definite advantages. For starters, some bonds actually can include a sinking-fund feature as part of the overall package, which makes it even easier to pay it back. Not only does using a sinking fund mean you're better able to set aside funds that'll pay off your bond (or debt) when it reaches maturity/is due, but it also ensures you avoid the sticker shock of your debt's total value when it comes due. By adding to a sinking fund in smaller amounts over time, you can plan for the future while dramatically decreasing the likelihood of ever defaulting on what you owe.

There are some things to keep in mind when it comes to building up sinking funds. Much like other savings or emergency-fund strategies, determining whether to prioritize debt repayment or savings can be difficult. Plus, by setting aside money for future expenses or repayment, you limit the amount of available funds you have in the present. For businesses (or involved personal investors), this lack of money in the present could limit potential investment and return opportunities. However, having the necessary funds to pay off a debt or make a large purchase in cash (from a sinking fund) can be more of a guarantee than any potential investment. This can be especially important for businesses, when having sinking funds can also help with things like creditworthiness in addition to improving cash flow and profitability.

The good news is that, if you're looking to say goodbye to big-purchase guilt and pursue a sinking fund, the process is fairly easy. There are myriad ways to create a fund, either through your existing bank or through another kind of account or institution. The main thing to keep in mind is that this account is meant to save money, so avoid accounts with fees or required minimum balances. Also, remember to be very specific with this fund's use (whether you focus on debt repayment or upcoming large-purchases like a new car). By ensuring the fund is dedicated only to a singular goal or place, you can make sure you stick to, and hit, your savings or repayment goals.