What is a sinking fund and how does it work?
As of 2022, 46% of American households owed money on credit cards, according to that year's Survey of Consumer Finances conducted by the Federal Reserve. With a sinking fund, you set yourself up with cash reserves so you’re not forced to rack up debt for a one-off purchase like a big trip.
A sinking fund is a simple, effective tool to save for large expenses. It’s simply a dedicated amount of savings for a specific purpose. You can even have multiple sinking funds at the same time — for example, individual ones for travel, household needs and transportation.
Setting one up is straightforward:
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- Open a savings account dedicated to your goal.
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- Contribute regularly, either monthly or per pay period.
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- Give yourself enough time to meet your target.
For example, if you’re planning a European vacation in 2025, you’ll want to set a budget. Then, figure out how many months or pay periods you have between now and your anticipated trip date. If it’s nine months away and will cost $3,600, you’ll need to contribute $400 a month to a sinking fund to pay for your vacation in full.
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Read MoreSinking funds vs. emergency funds
Let’s be clear on one thing. A sinking fund is not your emergency fund. And you also shouldn’t use an emergency fund to cover an expense like a vacation.
- Emergency funds are for unplanned expenses, like a car engine that won’t start, or a period of unemployment. The general recommendation is to aim for enough money to cover three to six months of bills.
- Sinking funds are for planned expenses, like vacations, weddings or big purchases.
A European getaway is a planned expense, so it belongs in a sinking fund — not your emergency fund.
Why sinking funds are worth it
The nice thing about sinking funds is that they can help you avoid debt while allowing you to meet a specific savings goal. When you charge an expense on a credit card and don't pay your balance in full, you sign up to pay interest. You also risk damaging your credit score if your balance gets too high, relative to your total spending limit.
A sinking fund can help you avoid these consequences. It can also help you avoid feeling guilty for spending a large chunk of money on a non-essential expense. If you know you've been saving for a trip specifically, there's no need to have second thoughts about raiding your savings to pay for one.
With a sinking fund, you can ensure you’re working toward your top goals. If you’re prioritizing a vacation but are also saving for a new car, you could dedicate a separate fund to each goal to stay on track. If you lump all your savings into one account, you might fall behind on individual goals.
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Learn morePotential drawbacks
Sinking funds, by nature, are funded gradually. If you don't have the time to save the money for a specific expense, this method may not work for you. Also, there's always the risk of dipping into that money prematurely. You'll need to be very disciplined if you want to save for a trip.
If your plans change, because of a wedding or another life event, you’ll have less time to meet your goal.
Sinking funds are a good place to park cash for a specific expense, including a big trip. Financial guru Rachel Cruze calls them "the perfect way to save up for any large expense," and they can help you enjoy your European getaway without guilt or debt holding you back.
If you’d rather just use a single savings account for all of your big purchases, that works, too. But it’s best to keep your emergency fund separate so you don’t end up dipping into that money for non-emergency purposes.
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