What are sinking funds?

Sinking funds, traditionally a business term, is an essential concept in personal finance. In general terms, sinking funds are money reserved for a certain purpose, usually an irregularly occurring expense. Here's how to use it for your personal budget.

Think about all the irregular purchases you make during the year. Typical irregular purchases include gifts, membership dues, taxes and vehicle registrations. For example, we have an Amazon Prime membership. The cost per year for that service is $79. Divided by 12, that is roughly $6.58 per month. Each month, $6.58 is set aside into a reserve account so that when membership fees are due, we have the funds available. This eliminates the "surprise" of having to pay an $80 expense.

It's simple enough, but neglecting to include these little items in your budget can seriously throw you off track, especially if you're working to become debt-free. Expenses like these are often a contributing factor to credit card debt. So, do yourself a favor now, figure out all your irregular expenses and work them into your budget.

To manage your sinking funds, I'd recommend a savings account that can be divided into sub accounts. ING (now Capital One) is a popular choice for such accounts. SmartyPig is another option, and the one that I personally use.

Dividing your savings account into sub-accounts (or goals, as they are called with SmartyPig) lets you easily identify where the funds should go. Otherwise, you'll have a lump sum in one account and may not be able to determine how much was set aside for each expense. When you need funds for that irregular expense, simply transfer it from savings to your checking account. Sinking funds are a great way to evaluate and manage your expenses, including those that are not always anticipated. 

If you budget, do you set aside funds for these irregular expenses? How do you do it?

Image courtesy of Flickr user aresauburn.