What is the difference between an emergency fund and a sinking fund?
The foundation of financial planning is savings. When you save, you secure your financial future and make it easier to fund your dreams.
Often when we talk of savings, we focus on retirement. But, there’s so much more to savings than that. The clearly named emergency fund, and confusingly named sinking fund are two important tools you can use to save well.
To help you harness the benefits of each, we’re going to define and compare them both.
What is an emergency fund?
An emergency fund is pretty much what it says on the tin: money held in reserve that you only touch in the event of an emergency, i.e. an unplanned, essential expense. A properly funded emergency fund should cover 3-6 months of regular expenses.
Though it may be tempting, your emergency fund shouldn’t be used for discretionary spending, like a vacation, or foreseen expenses, like putting new tires on your vehicle. It should be saved for true financial emergencies that you don’t have the luxury of saving towards.
What’s it used for
- Job loss
- Unforeseen medical procedures
- Car repairs
- Costly vet bills
- Home repairs, such as a leaking roof or broken HVAC
Benefits of an emergency fund
Emergencies can be taxing physically, emotionally and even relationally. Adding a financial burden increases the stress of the moment, and may have negative consequences down the road, whether that’s high-interest loans or owing money to family members.
Having an emergency fund allows you to sidestep the financial pressure when all the other pressures in your life start to increase. This makes it easier to navigate the emergency and easier to bounce back financially after it’s all over.
Where should you keep your emergency fund?
The most important part of your emergency fund is that it can be easily and quickly accessed in the case of an emergency. A secondary concern, as with all savings, is inflation. You don’t know when you’ll need the money from your emergency fund. It could be tomorrow or ten years from now. So, you want to ensure that you’re getting some interest on your savings so that inflation doesn’t decrease your spending power while you're saving.
The easiest way to do that is to start a savings account that pays you interest. However, some people may also choose to keep their emergency account in a TFSA, where it can earn more, but may be subject to longer withdrawal times. When investing your emergency fund, it’s important to keep in mind that it will be subject to good months and bad months. That may mean that your fund is low when you go through an emergency, leaving you stuck taking out money at an inopportune time. For that reason, invest in low-risk savings vehicles.
What is a sinking fund?
Unlike the emergency fund, the name can cause confusion because it’s not straightforward. Instead, it comes from the investment world, where sinking funds are used for paying off debts or bonds.
For personal use, a sinking fund is simply money held in reserve for a specific, planned expense, whether that’s mundane, like a new set of tires, or exciting, like a trip to Europe. You can choose to have one sinking fund, where all your planned expenses are paid for, or one for each expense – the method is up to you. For some, a simple spreadsheet tracking the savings will do, others choose to open separate accounts.
Benefits of a sinking fund
The biggest benefit of a sinking fund is you can move potential costs from your reactive emergency fund to your proactive savings. This adds more stability to your finances.
It also allows you to sidestep any interest you would pay by funding vacations or big expenses on your credit card. That alone makes each big purchase a little easier. And, when you plan for big, non-essential purchases, like the tropical getaway you desperately need, you can also avoid the post-purchase guilt that can steal the joy from your vacation (or other large, discretionary purchases).
What’s it used for?
New tires for your car
- Christmas gifts
- Vet bills
- Weddings
- Vacations
- Home remodels
- Concert tickets
- The coat you think is too expensive
How to Create a Sinking Fund
Step 1: Decide on how much you need to save
The amount you need to save depends on what you’re saving for. So the first step is figuring out the cost of what you want. That’s your goal. Once you’ve decided on your goal, divide that by the number of months between now and the predicted time of the expenditure. Then, you’ll know exactly how much you need to put away each month to meet your goal.
Step 2: Decide where to put your savings
Of course, it’s nice to have a little bit of interest for your savings, but keep in mind you don’t want to have a minimum balance to maintain, as this account will naturally increase and decrease quite a bit. You’ll also want to avoid monthly fees that will take you off track.
Because of that, a savings account is a good choice. Of course, you don’t have to open a new account. You can just use the savings or chequing account that you already have. Just make sure to track the accumulation via spreadsheets or budgeting apps.
Step 3: Work it into your budget
A sinking fund only works when it's added to your monthly budget. So, however you choose to track your budget, make sure the contributions get added in. Often, automated deposits work best.
Saving towards a better future
Saving can be difficult in the moment. However, once you get in the habit, savings will make it easier to get what you want, whether that’s by helping you avoid going into debt in emergencies or saving up for that vacation.