You’re probably already familiar with what an emergency fund is, but have you heard of a sinking fund? Though both serve the purpose of improving your financial security, the two have distinct purposes. In this article, we’ll get into what a sinking fund is, how it differs from an emergency fund, and show you practical tips on how you can get started on one.
What is a Sinking Fund?
According to Investopedia, the technical term “sinking fund” is traditionally used for businesses that have floated debt in the form of bonds to gradually save money and avoid a large lump-sum payment at maturity. In simpler terms, it’s a financial strategy that helps companies to systematically manage their debt obligations responsibly.
You can apply this concept to managing your personal finances. Essentially, a sinking fund is a dedicated amount of money set aside over time to meet a specific future expense or financial obligation. They’re the perfect way to save up for any large expense.For example, you might use a sinking fund to systematically pay off debt on a house or a new car to reduce interest costs, or even for asset replacement when you need to replace something expensive.
How Much Do I Need in a Sinking Fund?
How much you choose to set aside for your sinking fund will depend on what you plan to use your sinking funds for. To determine the amount to keep in a sinking fund, identify and list the anticipated expenses and their estimated costs. Divide each expense by the number of months until it's due.
A simple example would be a total expense of RM2,500 due in 12 months; you should set aside RM208.33 per month for your sinking fund.
(Use a sinking fund calculator to help you calculate the annual interest rate and compound frequency.)
Setting Up Your Sinking Fund
Step 1: Decide what your sinking fund is for. Whatever you choose to have a sinking fund for—a cruise, a new laptop, etc.—it’s best to start planning for it early.
Step 2: Use a separate account to store your funds.
I always recommend that you park your money in a cash app. It’s the easiest way to grow your money without doing anything! Some great apps you can use are GXBank, Versa Cash, TnG GO+, and StashAway, as they offer daily to monthly returns ranging from 3.5% to 4%. For example, if you continued to save RM200 every month in Versa for 6 months with an interest rate of 3.8% p.a., your money would grow to approximately RM1,204.60, thanks to the compound interest.
Step 3: Stick with it!
Whatever your financial goal may be, consistency is key. Set up automated transfers from your main account to your sinking fund account to maintain the buildup. You’ll need to practice discipline to resist the temptation to dip into your fund for other purposes.
What is an Emergency Fund?
It is a fund that is set aside to pay for unexpected expenses such as unforeseen car repairs, medical expenses, or unemployment.
How Much Should I Save in an Emergency Fund?
The Employees Provident Fund (EPF) suggests that you save three to six months worth of your salary as an emergency fund. Depending on your financial obligations, you could opt save more. Ultimately, having an emergency fund is a must, as it provides a buffer between you and financial disaster.
Sinking Fund vs. Emergency Fund
The key difference between a sinking fund and an emergency fund boils down to planning versus unpredictability. A sinking fund is for those big-ticket items you know are coming—like buying a car or going on vacation—where you can plan and save with a clear goal in mind. On the other hand, an emergency fund is your financial safety net for when life throws you a curveball, like an unexpected car repair or medical bill, where you can’t predict the cost or timing.
To manage both effectively, prioritise building your emergency fund first to ensure you’re covered for the unpredictable. Once that's in place, shift focus to creating sinking funds for your planned expenses.
Conclusion
Both an emergency fund and a sinking fund play an important role in your financial plan, but they have very different purposes. To make the most of your savings, I would recommend that you use both to help you on your financial journey.
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