How a sinking fund can help you meet predictable one-off expenses

The cost of buying a new AC, doing up your house or planning a vacation is spread out over the entire year instead of hitting your budget hard in one month

Money doesn't come easy. But, if you manage it well, there's a good chance you will end up rich. Mumbai-based certified financial planner Pankaj Mathpal says, "When it comes to expenses, there are two types, the unexpected and the expected ones. And, you have to incorporate both in your monthly budget for efficient money management." You might have heard of setting up an emergency fund as a money management technique. But, did you know that you also need a sinking fund as a part of your monthly budget? 

What is a sinking fund? 

It is the money we keep aside for predictable expenses that are not incurred monthly, but may come at a set date in the future. They may also come out of nowhere, yet they are predictable. Mathpal says, "A sinking fund is simply a strategic way to save money by setting aside a little bit each month. For instance, in a humid place like Mumbai, the air conditioner needs a replacement every fourth or fifth year. If you are lucky, it may last longer. You don't know the exact day, but someday in the future, it has to be replaced. Maybe you want to renovate the house, every three or five years down the line to keep up with the changing needs of your family." Planning for Diwali expenses or spending on a yearly home town visit also can be done using a sinking fund. 

Why do you need a sinking fund? 

By setting aside a little bit each month, you can spend big without hurting your cash flows. Mrin Agarwal, Financial Educator, and Director, Finsafe India Pvt Ltd says, "Here the cost is spread out over the entire year rather than hitting your budget hard in one month." In short, sinking funds spread out your significant expenses over a long period. For instance, if you know you have a ULIP premium of Rs 24,000 coming every November, instead of taking that huge chunk out of your October salary or using your credit card, a sinking fund will help you save a little every month, so that you can pay the lump sum in November without too much stress. 

Sinking fund versus emergency fund 

Don't confuse a sinking fund with an emergency fund. The latter is kept aside for unexpected events such as a job loss or a medical emergency. Mumbai-based certified financial planner Kiran Telang says, "In an emergency fund, you usually keep a minimum of six months' expenses set aside. This includes monthly living expenses, lifestyle expenses, as well as EMIs for your loans. A sinking fund can be used to pay for planned expenses such as a holiday or annual expenses like school fees." 

Sinking fund versus savings account 

Don't confuse a sinking fund with the savings account. Agarwal says, "When it comes to money, many are very short-sighted. Savings for an anticipated future event in a savings account is a bad idea. Because of easy access to money, it's easy to divert the funds towards other needs. Also, you hardly get any returns in a savings account." 

How to set up a sinking fund 

Mathpal says, "Assets in a sinking funds should not be very liquid. I am not sayingthey should be illiquid like PPF, but they should not be as liquid as an emergency fund either. Here you need to have enough liquidity, but also earn some decent returns." 

For setting up a sinking fund, some planners prefer to increase the SIP amount of your existing emergency funds. Telang says, "To mentally keep emergency funds and sinking funds separately, you can keep the two separate. As far as sinking fund goes, for those in low tax brackets, a recurring deposit will work better. Others can start an SIP in a debt mutual fund." You can even choose to set up sinking funds as per your time horizon. Mathpal says, "For expenses between one and three years invest in debt-oriented hybrid funds. For a time horizon of more than three years, equity-oriented hybrid funds like Dynamic Asset Allocation or Balanced Advantage fund work well."

How much? 

Setting a sinking fund is both comfortable as well as difficult. For things like your vacation or home renovation, it's easy to estimate the cost. Divide the price by the number of months you plan to use the fund, and set an SIP accordingly. Expenses on gadget repair or replacement, yearly dental work, or car maintenance could vary. Telang says, "Even if you do not know the exact cost, it's still a good idea to set up a sinking fund for a major expense. That way, at least part of the expense is covered."

Companies maintain something along the lines of a sinking fund or a depreciation fund. Here an organisation sets aside an optimal amount of cash to pay for replacing an existing asset once it is no longer useful. Find out the depreciation on the item, and invest an equivalent amount in a sinking fund that you can use to buy a new asset. Agarwal says, "A sinking fund is used by housing societies to finance renovation of the building when it becomes due." 

Some useful numbers 

The size of the sinking fund you need to meet each goal will be specific to your individual need. But, certain thumb rules help. The rule of thumb when it comes to renovation is not to spend more than 10 per cent of the value of your property. So if your house is worth Rs 75 lakh, you should not spend more than Rs 7.5 lakh on renovating it. That would be Rs 12,500 a month. At the end of five years, you will get the required Rs 7.5 lakh, along with a small surplus. 

If the cost of repairing a gadget you own is working out to more than half its price, it is better to go for a new one. You must ideally create a sinking fund to buy a new device, but when the time arises, see if only a repair will do. Telang says, "For gadgets, you can keep aside Rs 5,000-10,000 as SIP, since every year something or the other breaks, needs repairs or renovation."

Money is a pretty powerful tool when you make it work for you. And, including a sinking fund in your monthly budget will give you more control over your finances.

How to build a sinking fund: An illustration
Target	Amount (Rs)	Years	SIP amount (Rs)	Rate	Total collected (Rs)	Surplus
Home Rennovation	7.5 lakh#	5	12,500	12%	1,013,793	263,793
Gadgets	Rolling	2	5,000	7%	128,860	8,860
Specific Gadget-Laptop	60,000	2	2,500	7%	64,430	4,430
Specific Gadget Repairs-mobile	7,500*	1	625	7%	7,781	281
#10% of home value of Rs 75 lakh; *50% of gadget value