What is a sinking fund?

If a friend mentioned a “sinking fund” down the pub, you could be forgiven for saying “what on Earth is that?”  It’s not the most inviting term, and it’s hardly everyday language. But in personal finance, it means something very simple. In fact, you’ve probably already thought about it without realising.

What is a sinking fund?

If you can see a cost coming, you should start saving for it. That’s the basic idea behind a sinking fund. 

A sinking fund is a savings pot set aside for a specific reason, so rather than keeping all your savings in one general pile and assuming it’ll cover your needs, you take the extra time to list what you know is coming down the track and organise your savings into different lanes. 

This extra bit of organisation can make a real difference in practical terms. Depending on what the cost is, how large it’s going to be and when it’s due, each sinking fund can be set up a little differently. And as with financial planning more broadly, the value lies in the exercise of looking ahead, imagining the future, coming to terms with what you really want or need, and then making room for it in good time.

How do sinking funds work?

To start with, car insurance, school uniforms, Christmas presents, a holiday, home repairs, or replacing something expensive when it finally gives up can all be reasons to set up a sinking fund.

In the example of school uniforms and school trips, you know they’re coming. Shoes, shirts and skirts go through the rough and tumble with kids and before long, they need replacing. Saving £30 a month now so you have £150 by the start of the new school year in September is a straightforward way to be prepared for that future spend, rather than be scrambling around.

The same goes for larger costs. A boiler may not need replacing this year, but if it’s ageing and you know a new one could cost around £3,000, it can make sense to start setting money aside in a sinking fund. If saving that money over three years feels realistic, that means putting aside around £80 a month. If the boiler fails earlier than expected, that’s where an emergency fund comes in. But if you’ve planned ahead, the hit is far easier to absorb and less likely to throw your finances off course. 

An important part of having multiple sinking funds on the go at once is to regularly review them. When bills are set to arrive, and how much they will be, can easily change with factors outside your control. 

Are sinking funds considered savings?

Yes, but they’re savings with a purpose.

Once money is in a sinking fund, it should be mentally and practically earmarked for something. Without this clear definition, it’s easy to either get anxious about your ability to meet future costs or fall into the trap of being too complacent. An array of sinking funds gives your finances more structure.

What are the main benefits of setting up a sinking fund? 

Having a sinking fund can take your personal finances up a level because it elevates something as simple as saving money with the rigour and detail you’d expect from professional financial planning.

1. It helps you find the right saving-to-investing balance 

Instead of saying “I can afford to save £300 a month” and treating one big savings pot as a catch-all for anything and everything, sinking funds give you a clearer view of your financial life. When you actually take a moment to envision the future – the demands on you and the lifestyle you want to fund – the savings goals become clear. You may realise that once you’ve mapped out your future needs, you don’t actually need to save that much and have more room than you thought to invest instead. And equally, it can work the other way. You may discover you need to save more than you assumed.

We recently wrote about using the 50-30-20 rule as a guide to spending, saving and investing. This can be a useful rule of thumb for what to aim for in your personal finances.

Read more: What is the 50-30-20 rule?

2. It reveals what financial products are right for you

The other advantage of the clarity that sinking funds give you is that you can pick specific savings products to suit the individual pots. Once you know what each pot is for, you can see where easy-access accounts are needed because the expense is coming up soon, versus where higher interest-bearing savings accounts which are best if the expense is distant and you have time to make your money work for you. High-interest savings accounts are usually less flexible, either locked or with withdrawal fees, so you’ll need to be sure of exactly when the money will be needed so you have access to it.

Read more: Types of savings account

3. It brings mental clarity and peace of mind

If you find it hard to stay disciplined with savings, sinking funds can help here too. 

There are good financial habits and bad financial habits. A bad one is dipping into savings for treats when you know you shouldn’t. But this is sometimes simply because the purpose of the savings pot is vague or abstract. There’s no reason you can give yourself to not go over-budget on a night out and get another round, other than “well, I suppose I should save this money” or “I’m not supposed to spend this”. A sinking fund solves that problem. Anywhere you pull money from is labelled. So, when you go to scan your card for that extra treat, reasons like “this is for the summer holiday with my kids” or “this is for their birthday presents” it acts as powerful reminders to leave the money alone.

4. It allows you to be more decisive 

Sometimes this kind of savings strategy can help you make better decisions about the expense itself. 

It’s common for surprise bills to cause a panic, and to push people towards the cheapest short-term fix, even if that means the problem is likely to come back again. But don’t just kick the can down the road. If your car is costing you money at every MOT, for example, starting a sinking fund to replace the car altogether could become part of a wider plan that’s better (and safer!) than lots of little running repairs.

How much should a sinking fund be?

Enough to cover the expected cost, with a little breathing room if the figure is uncertain.

Aiming slightly higher than your guestimate is wise when thinking about how much a sinking fund should be. And keep inflation in mind as well. Not only could it increase the amount you need to save if the expense is a long way off, but certain things are simply more exposed to price swings in the short term.

For example, if you rely on heating oil for your home, you’ll have felt the price increases because of the conflict in Iran. Households were paying an average of £2,564 for a year’s worth of heating mid-last month, compared to less than half that the month before. Truly stratospheric, and an example that goes to show that if you can fix expenses that are exposed to big swings, that’s often wise even if it means them being fixed at a slightly higher than normal level to what might be available variably.

Explaining the process of creating a sinking fund

So, how’s it actually done? These are the four definitive steps:

1. Start by listing your predictable non-monthly costs: Think through the year ahead and write down the expenses that are likely to come up outside your regular monthly bills.
2. Estimate the amount of money you are likely to need for each one: Last year’s spending can be a good starting point, though it’s worth adjusting if costs have changed.
3. Work out when you’ll need the money: If the expense is due in six months, divide the target amount by six. If it’s due in a year, divide by 12 for your monthly savings goal.
4. Choose where the money will sit: It could be a separate savings account or a low-risk investment option for longer-term goals. For short-term goals, cash will often make more sense than investing because the priority is stability and access rather than growth.

With Charles Stanley Direct Cash Savings, powered by Bondsmith, you can get quick and easy access to some of the best interest rates available, shown below. You can quickly and easily move from one deposit account to another, which is crucial in such a volatile world with expenses that can surprise you.

Find out more: Cash Savings | High Interest Savings Account | Charles Stanley

Creating a sinking fund is an exercise many financial planners love because it encourages forward thinking. The most challenging part is often taking the time to think properly about your life and what you might need money for. Involve your friends and family, if you wish – they might be able to offer a helpful outside perspective or share their own experience of what comes up. 

Sinking fund vs emergency fund

This is a question so many people have. It’s absolutely vital to make a sharp distinction between planned expenses and true emergencies. 

The reality is, many financial shocks are things we should’ve seen coming, but instead of saving in the lead up, we left things until the last minute. Allowing these to masquerade as emergencies is a bad financial habit because it blurs your sinking fund  and your emergency fund. 

An emergency fund is a pot of cash – safe, secure, and accessible whenever you’re blindsided by bad luck in life. It’s a fund for genuinely unexpected situations, such as a sudden loss of income or an urgent and unavoidable expense. If you want to know how much you need in an emergency fund, and a few best practices around setting one up, check out the article below.  

Read more: How much of an emergency fund should I have? | Charles Stanley

If you’re not careful, sinking funds and emergency funds can become one and the same if you use the emergency fund for general expenses or it’s always your savings that you raid when an unexpected bill lands. Your emergency fund should remain intact for those latter situations. After all, if you dip into it every time a predictable bill comes around, you never really have an emergency fund at all.

Here’s the truth: A sinking fund is for known or broadly predictable costs. An emergency fund is for unknown, unplanned costs. Here’s a quick guide if you’re not sure where something fits: