What is the difference between a sinking fund and an emergency fund?
A lot of people have heard about the importance of having an emergency fund, and they work hard to secure it. But today we’re going to talk about another kind of savings. And that is a sinking fund. Both are equally important, and having both will ensure that you a financial foundation that can weather many kinds of economic downturns including recessions, lay-offs and other unexpected costs.
What is the Difference Between Emergency Fund and Sinking Fund?
Emergency Funds are for Emergencies Only
First off, what is an emergency fund? An emergency fund is literally for things are an emergency. Those are things like job loss, medical leave, car accidents or other accidents. They are also for circumstances if there’s a death in the family and you have to travel or take some time off to take care of loved ones. Emergency funds for true unexpected emergencies.
Then there is another type of savings called a sinking fund. The concept of a sinking fund comes from municipal government finance for bond repayments. When Cities and governments borrow money, they know somewhere down the line they have a liability that they have to pay back.
Because the future cash flows are known, and they know when it’s due, they start putting aside a little bit of money every year to pay for it at the end. But what if we could apply the same principle to our household budgets? If it works for cities, it can work for us too.
Sinking Funds On a Budget
In our own budgets, we know that there are certain bills that are going to come up in one or two years or every year at a certain time. Things of this nature would be replacing your water heater, certain kind of maintenance on your car. Maybe in three years’ time, you have to replace the tires for your car. That’s an outlay of expense you know you’re going to incur somewhere down the line. These could also be for buying a new fridge and replacing things your household, or your lifestyle, requires.
To set up a sinking fund, we would put aside a bit of money every paycheck for these known expenses that are down the road. You might have three sinking funds for example; one for a new fridge, one for new tires and one for a water heater.
You could either put a certain amount of money aside for each sinking fund every paycheck or fund one at a time. Maybe I’m going to take care of the fridge first. It’s going to cost me $800 to replace the fridge so I’m going to save $50 a pay until I get to $800. After that, I’m going to start on the “new tires” fund, that’s $400 and then after that, I’m going to work on the “water heater” fund.
And that’s the difference between an Emergency Fund and Sinking funds. What I recommend is to keep sinking and emergency funds separate.
One Pocket for Emergencies and Another for Sinking funds
Why? Because money is what we call fungible. $1 for emergency fund looks exactly like the $1 for a water heater replacement fund. It’s hard to tell which dollar is going where if you’re just looking at $1 bill. If we throw all the $1 bills in the same jar, we don’t know what bill is for which cause.
What I like to do is to put them in separate places. My emergency fund and my sinking funds are not in the same account. This way I can see exactly where I stand on each. I know how much more I need to save to reach my goals.
Another advantage of keeping an emergency fund and sinking funds separate is that it allows me to make the best decision for each. For example, maybe for the sinking fund for the fridge, I might keep that in a high-interest savings account because it’s $800 that I might have to spend next year or in 3 years. I’m not sure. But when I need it, I’ll need to access that cash right away.
Timelines and Decision Making
But for an emergency fund, it’s a lot more money to have sitting in a bank account earning very little. The rule of thumb for an emergency fund is three to six months of expenses. This is generally thousands of dollars. That is supposed to allow us to pay our bills until we can find other forms of employment without going into debt. We know that debt is a hole that is hard to get out of. Another scenario is the fund to cover medical leave.
So when you stop to think about it, the chances of us needing to use our emergency fund is actually pretty low. At least we hope.
We hope that there is no unexpected job loss and we hope there are no unexpected emergencies for medical reasons. In this case, we could invest this larger amount of cash for a little bit longer. It would allow the emergency fund to earn higher interest rates than fridge replacement. What we could do is commit them into a higher interest rate certificate of deposit note.
Fear and Greed Are Devils Standing on Our Shoulders
It’s important not to get greedy here. Some people will take this as a license to dump all that cash into the stock market hoping to make more and more. But we must show restraint here. By investing in deposit notes or certificates, we earn more on it than our fridge fund all the while keeping it in a very safe place.
Now you can see why I had called these 2 types of funds the foundation of our financial house. With sinking funds, we look after shorter-term needs and with an emergency fund, it’s a kind of insurance against a lay-off. By having both, it ensures we stay out of unnecessary debt.
How This Fits Into the Larger Financial Picture
The importance of having these 2 types of funds has to do with the rest of our investments. Once these are set up, we no longer have to be afraid of investing. We are free to invest any money we have on top of these funds so that we can take advantage of the wonders of compounding.
A lot of people say, “Oh, I’m afraid to invest because I don’t want to lose my money”. On the surface that is a valid reason. However, if we dig a bit deeper and ask why does this scare them, the reason is based on cash flow. Of course, we are afraid to lose our jobs. Of course, we worry about the fridge konking out. We are afraid to invest the money because we are afraid that money won’t be there when we need it.
With we have a sufficient emergency fund and a sinking fund, we have what we need to take care of all of our cash flow needs. These funds will be there when we need them.
Sinking and Emergency Funds in Investing Asset Allocation
This means all the rest of our savings can be invested in stocks and bonds so that it grows our wealth and allows compounding to work in our favour. As I show in this article, asset allocation is the biggest factor in returns.
Because cash and savings have a lower return, a pot of money invested in savings only won’t earn as much as a pot invested in stocks. As long as we have these funds in place, the rest of our money can be invested in long term strategies and not sitting in cash.
By dividing our asset allocation pies this way, we can optimize our money and each dollar is doing a job.
Conclusion
So to wrap up, we see that sinking funds are indeed very different than an emergency fund. Emergencies are unpredictable, but our car maintenance schedule is less so. With sinking and emergency funds, we take care of the short-term and the “what ifs”. We invest excess money to take care of our retirement and our long term financial well-being.
With that kind of foundation, no wolf will blow our house down.
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Thanks for this easy to follow guide on saving for both emergencies and planned expenses. Saving for both is so important.