An emergency fund and sinking fund may sound kind of similar, but they are actually very different tools both aimed at improving your financial security. Let’s look at the differences.
What is an emergency fund?
Good cash management means putting funds away for a rainy day in case you’re hit by a big cost that comes out of the blue—like an illness or a car breakdown.
This is where an emergency fund comes in. It delivers a financial safety net so you don’t have to get a loan if something untoward and unexpected happens to you or your family.
How much do I need?
There’s no strict rule here, but when it comes to an emergency fund, more is better. Even if you can only save a little at first, it’s a good idea to start, and to do it regularly.
For instance, if you put $40 a week into a savings account, you’ll have over $2,000 by the end of the calendar year, which will give you something to fall back on if a crisis hits.
Experts suggest that a good general target is to have enough money in your emergency fund to cover three months of expenses at a minimum.
How to save for an emergency fund
Sticking to making regular payments is often the hardest part when it comes to building an emergency fund.
When it comes to this part of the equation, some ideas to take the sting out of it include setting up a separate savings account, automating your savings, and maximising your offset account if you have a home loan.
How is a sinking fund different?
In business the term ‘sinking fund’ has a specific technical meaning, but when used in common parlance it refers to a strategic way to save money by regularly setting some aside.
A sinking fund is completely separate from your savings account or your emergency fund, and can be used to save up for things like home repairs, a holiday, or a new car.
Simply put, while your emergency fund should be reserved for something that comes at you unexpectedly, the idea of a sinking fund is to save for a specific and planned expense.
How to create a sinking fund
There are few simple steps here. First, dedicate a savings account to hold your sinking fund in, that you won’t access for other expenses. It can help to give the account a name in line with the expense or saving goal.
Next, you need to decide how much you’re going to store in your sinking fund as a starting point. This will likely depend on your individual financial circumstances and the goal you’re aiming at with the fund, such as whether it’s for a new car or a weekend getaway.
From there, you’ll need to decide how much you’ll put away in the sinking fund on a regular basis whether that’s weekly, monthly or quarterly.
How much should I have in a sinking fund?
Unlike with an emergency fund, the amount you need in a sinking fund account depends on the estimated cost of the expense. Once you’ve accumulated that amount, you’re able to spend it for the specified expense.
Another way to organise your sinking fund to guide your saving—if you want to get a bit fancier—is to split it into categories of expenses in line with your goals. You can deposit money for recurring expenses like taxes, subscriptions and insurance premiums, one-off purchases like a new computer or car, and then large events like anniversaries or birthdays.
Remember, the bottom line is that emergency funds and sinking funds are not mutually exclusive – both mechanisms are ways to take greater control over your finances and are ways to give you more financial freedom in the long term.