Sinking Funds for Predictable Expenses

The car insurance renewal, the property tax bill, the holidays, new tires, the annual software subscription: none of these is a surprise, yet each one arrives feeling like one. When a predictable bill lands on a month with no room for it, it goes on a credit card or comes out of the emergency fund, and the plan takes a step back. A sinking fund is the fix. This chapter explains what belongs in one, how to size it, where to keep it and what to do when reality does not match the estimate.

What a sinking fund is, and what it is not

A sinking fund is money set aside a little at a time for a specific expense you know is coming. The name comes from old corporate finance, where a company put money aside each year to retire a bond when it came due. The household version works the same way: you turn one large, lumpy bill into small, even monthly amounts.

It is different from an emergency fund. An emergency fund covers what you cannot predict: a job loss, a medical event, a sudden large repair. A sinking fund covers what you can: the bill that comes every year, or the replacement you know is a few years away. Keeping the two apart matters. If the holidays are paid from the emergency fund, the emergency fund is quietly smaller in January, exactly when you might need it.

An expense is a good candidate when it has three features:

• Predictable. You know it is coming; only the exact date or amount is uncertain.
• Periodic. It recurs on a schedule, or at least within a range of years.
• Large enough to hurt. Paid in one go, it would strain a normal month.

The categories most households need

Lists vary, but most sinking funds fall into four groups.

Annual bills. Insurance premiums paid yearly (often cheaper than monthly), property tax if it is not paid through the mortgage, vehicle registration, professional dues, memberships and yearly subscriptions.

Upkeep. Car maintenance and tires, home maintenance, routine medical and dental costs, prescriptions, pet care. A common rule of thumb for home upkeep is 1% to 2% of the home's value a year, more for an older home.

Seasonal and planned. Holidays and gifts, birthdays, back-to-school, travel, seasonal clothing.

Replacements. The next car, a roof, a furnace or water heater, appliances, a laptop. These are the largest and the easiest to forget, because they come every five to fifteen years.

Medical costs deserve a note of their own. A fund that reaches your health plan's deductible means a planned procedure or an unexpected visit does not have to be financed. If you have a health savings account, it can play this role with a tax advantage, which chapter 6 covers.

The arithmetic: one bill becomes twelve small ones

For a yearly bill, the monthly amount is the yearly cost divided by the number of months until it is due. If the renewal is twelve months away, setting aside $100 a month builds exactly the yearly bill:

Twelve deposits of $100 make $1,200, ready on the due date. If the bill is only eight months away when you start, divide by eight instead, then drop back to the twelve-month amount once the cycle has reset.

Now look at the same bill without a fund. Put on a credit card at 22.0% and paid down at $60 a month, it looks like this:

It takes 26 months to clear and costs $309 in interest. By then the next renewal has already arrived, and the one after that is on its way. That overlap is how a predictable bill becomes a permanent balance.

For irregular costs such as car repairs, average the last two or three years and round up. Some months nothing happens and the fund grows; then a brake job empties it. That is the fund working, not failing.

For replacements, divide the expected cost by the months you have left. A car fund started four years before the next purchase, at $400 a month in a savings account paying 4.0%, grows like this:

It reaches $20,754, with $1,554 of that earned as interest rather than paid as interest on a loan. Chapter 3 shows how much a smaller car loan, or none, saves.

Where to keep the money

There are three common set-ups.

One account and a spreadsheet. All sinking fund money sits in one high-yield savings account, and a spreadsheet tracks how much belongs to each category. It has the fewest accounts and earns the most interest on the total, but it depends on keeping the spreadsheet current.

Buckets inside one account. Many online banks let you divide a savings account into named sub-accounts or "buckets" and split each deposit automatically. You see each fund's balance without extra accounts. For most people this is the easiest to keep up.

Separate accounts. One account per major fund gives the clearest boundaries, at the cost of more logins and statements.

Whichever you choose, keep sinking funds in an insured savings account, not in investments. The money is needed on a known date, and a market fall just before a bill is due defeats the purpose. Chapter 4 explains how to pick the account.

When the fund and the bill do not match

Estimates are estimates. Three situations come up, and each has a simple rule.

The bill is bigger than the fund. Cover the gap from another sinking fund that is ahead of schedule, or from the emergency fund if there is no other choice, then raise the monthly amount until the fund is back on track. Next year, raise the estimate.

The fund is bigger than the bill. Keep a small cushion for next year's price increase, and move the rest to your top goal. A sinking fund is meant to match its bill, not to grow forever.

The expense goes away. If you sell the second car or cancel the membership, close the fund and redirect its monthly amount to another goal straight away, before it is absorbed by everyday spending.

Set it up in four weeks

Week 1, find the bills. Go through the last twelve months of bank and card statements, and your calendar, and list every expense that is not monthly. Note the amount and the month.

Week 2, do the math. Work out a monthly amount for each, add them up, and make room for the total in your budget. If the total is more than you can manage, start with the largest bills and the ones due soonest.

Week 3, build the accounts. Open the account or buckets, name each fund plainly, and set an automatic transfer for the day after payday. Chapter 5 covers timing.

Week 4 onward, pay from the funds. When a bill arrives, pay it and move the matching amount from its fund. Adjust estimates once a year.