Thursday, September 25, 2008

Sinking Fund

Most of the personal finnance blogs I read talk about the importance of an emergency fund. Most of them recommend building up as much as you can as quickly as you can, and maintaining some amount ranging from 3 months worth of living expenses up to as much as 3 years worth.

I always used to have trouble with this concept. I would start to save money, but then I would start to think to myself that if I invested this money in my retirement account I would be ahead as long as an emergency didn't crop up. Even if one did, I wouldn't really be further behind, because I could just cash in some of my retirement investments for use to cover the emergency. As far as I can tell, this is a legitimate outlook. The only danger is that because my retirement fund is primarily invested in potentially volatile vehicles (mainly stock based mutual funds) I could theoretically have been forced to 'sell low' and thereby lose some money.

All that changed about 3 years ago when I came up with the concept of the sinking fund. I'm not pulling an Al "I invented the internet" Gore on you; I'm not formally educated in financial matters and only heard the term 'sinking fund' a couple of years after I came up with my idea. The fact that the concept is actually a few hundred years old is, to me, completely irrelevant ;) . I listed all the things that don't normally go into a household budget because they are unpredictable, like reroofing the house, replacing appliances, replacing windows, etc. I then assigned each item a lifespan and a cost; for example, I estimated that a roof was good for 20 years and that it would cost $5000 to do the roof on my 3 bedroom bungalow. I then divided each capital cost by the lifespan in weeks to get the weekly cost to replace that item (I get paid weekly). In my roofing example, the weekly cost would be $5000 / (20 years x 52 weeks) = $4.81 per week. In actual practice, I don't have a seperate account for roofing and one for windows etc., but I rather have them lumped into one item called househoold maintenance.

About a year ago, I ran across the term sinking fund somewhere in my reading. It is commonly used by companies to repurchase outstanding bonds, and often talked about by governments (but seldom well impemented) to save for "rainy days" or large upcoming capital projects.

This has been working out great for me. For the first time ever, I have an actual bank account that has grown to a significant number. Because it is earmarked for something specific, I find it much easier to keep my hands off of it. Even though it's necessity is questionable, it certainly feels good to have cash available if something unexpected crops up. I actually used it twice so far, once to reroof the house, and another time I had to replace my clothes dryer. It's held in a high yield savings account (President's Choice Financial currently paying 3.05%), and actually throws off a few dollars in interest income as it continues to grow.

My next goal is to start to build up a similar fund for my car. This is a lower priority than my house, because my car is relatively new and therefore (hopefully) won't be requiring any major repairs. However, I do plan to keep this vehicle a few more years, so things may crop up, and there is also the possibility of an accident.

So I have a sinking fund instead of an emergency fund. When you get down to the nitty gritty, the difference is more one of semantics than anything else; the fact of the matter is if an emergency not included in my sinking fund plan came up (like unemeployment) I would use it for that purpose. But the way I have labeled it has made it possible for me to let it grow.

1 comment:

Retired Syd said...

Hey, I like the term sinking fund for cash even in retirement: money you can use to buy stuff when the rest of your assets are sinking!