When I started budgeting for the first time, I would get so frustrated because I felt like I was doing really well. But then one big expense would come up and throw off my entire budget for the month.
Sometimes it was unexpected car repairs or a medical bill I didn’t plan for. But other times it was expenses I knew about and just didn’t plan for, like my vehicle registration or my Amazon Prime subscription.
This went on for years until I found two simple tools to help me avoid these budget mishaps: sinking funds and emergency funds.
What is an emergency fund?
An emergency fund is just what it sounds like — it’s a chunk of money set aside for emergencies. First, an emergency fund can be used for large unexpected bills. But more importantly, it can replace your income for a short time if you unexpectedly lose your job.
Experts generally recommend having at least 3-6 months of expenses set aside in your emergency fund. That’s enough to give you some breathing room in case you lose your job.
In light of the pandemic, it’s more important than ever to have an emergency fund. And if it’s feasible for you to save more than 3-6 months of expenses, I definitely recommend it.
How to build an emergency fund
To build your emergency fund, start by figuring out just how much you want to save. And remember that saving 3-6 months of expenses doesn’t necessarily mean saving 3-6 months of income. If you lose your job, assume that you’ll cut out some of your discretionary spending. It really only needs to be 3-6 months of necessities.
Once you know how much you want to save, you can start transferring money into the account each month. I do recommend keeping this money in a separate savings account — preferably a high-yield savings account — so you’re never tempted to spend it.
What is a sinking fund?
A sinking fund is a saving strategy you can use to save all year long for expenses that come up only occasionally. For example, let’s say you spend $600 per year on Christmas. Instead of spending $600 out of your December budget and likely going way over budget for the month, you would save $50 per month throughout the entire year.
Sinking funds can be used for three types of expenses:
- Planned expenses like your vehicle registration or Amazon Prime subscription
- Unplanned expenses like car repairs
- Savings goals like a vacation or the down payment on a new car
Sinking fund categories
There are so many categories you can make sinking funds for. And honestly, once you get the hang of it, you’ll be excited to set up more sinking funds. It’s kind of addicting! Here are some examples of sinking funds you might have:
- Vehicle registration
- Car repairs
- Car insurance
- Home repairs
- Medical bills
- Pet expenses
- House downpayment
- Association dues
- Car replacement
- Kid-related expenses
- Annual subscriptions
- New appliances
How to build sinking funds
To build your sinking funds, start by figuring out how much you want to save for the entire year. For some categories, this will be easy. You can easily figure out how much you’ll need for your annual subscriptions or vehicle registration.
But it might be more challenging to figure out how much to save for unplanned unexpected like medical bills and car repairs. For those, you can page through your old bank statements to get a good idea of how much you spent last year.
Once you know how much you want to save throughout the entire year, simply divide that by 12, and you know how much you’ll want to save each month.
Both your emergency fund and your sinking funds are an important part of your financial plan, but they have very different purposes. To make the most of your savings, I recommend using both! Your sinking funds will help you budget for expenses both planned and unplanned that come up only occasionally, while your emergency fund is there to protect you in case of a job loss.