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Personal Finance 101 – Sinking Funds

Tsh — Fri, 07 Mar 2008 19:07:26 +0000

As you know, our money strategy is to follow Dave Ramsey’s baby steps, and in my recent post explaining Baby Step 3, I mentioned “sinking funds.” It’s a simple financial strategy, and it’s not new, but it has enormously helped our family’s finances. And I encourage you to start using sinking funds even while paying off debt via the debt snowball.

Photo by Ironic Tonic

Simply put, sinking funds are a reserve of money set aside for some purpose. It’s a commonly used business and government practice, and it should be part of a healthy personal budget as well. If you think of your family as a company that you’ve been assigned to manage, it would only make sense to make sure you have funds readily available for the many things that surface on any given year.

Think of all those non-monthly payments or purchases you face on a regular basis. For some people, auto insurance shows up once or twice a year. What about new school clothes for your kiddos? These aren’t things you spend money on each month, but you still need to pay for them when they show up.

Nothing can screw up a debt-free plan quite like these irregular expenses. In fact, I’ll bet that’s how many people find themselves in debt.

“What? Christmas is only three weeks away? There’s no money in the budget – I guess we’ll have to whip out the Master Card.”

“Why oh why did our insurance bill arrive just when we had to pay for Sally’s recital costume? Looks like it’s Visa to the rescue again.”

If you know these irregular expenses are headed your way, it would only make sense to set aside a small portion of each budget towards them. This, in a nutshell, is sinking funds.

Christmas is an easy example. Let’s say you calculate a need of $500 for your Christmas holiday (gifts, decorations, cards, extra food – the whole shebang). It’s now March 7, about nine months away until the next season. If you didn’t start saving for Christmas 08 in January 08, that means you have nine months to complete your Christmas 08 fund – and 500 divided by 9 is $55.56. That’s how much you should list in “Christmas” as part of your regular, monthly budget.

(A side note: some people prefer to budget according to their paycheck, not just by the month. If this is you, and if you get paid biweekly, then you’ll calculate how many paychecks you anticipate from now until Christmas, and divide into that number, not the months.)

Sinking funds is an easy enough concept. But like many things in life, it’s one thing to use this method on paper; it’s quite another to put your money where your… idea… is. Sinking funds can get really fuzzy and confusing when they’re all lumped together in one savings account. Even when you keep detailed monthly records of what dollar is assigned to what, all this can rapidly become overwhelming. At least it did for me.

That’s why sinking funds didn’t work for us… until recently. Thanks to ING, we can open as many savings accounts as we want, and it doesn’t cost us a dime. We can even customize each account with a different name, and we can seamlessly automate transfers from our checking account to our various savings accounts.

We currently have five savings accounts, respectively named “Emergency Fund,” “Giving,” “Holidays & Gifts,” “Vacation,” and “Work Expenses.” Each month when our paycheck arrives, we have ING automatically transfer a set amount from our checking account into each of these accounts. Most of the money stays parked in these accounts for months at a time, until expenses arise that fit these categories.

When we need funds for these categories, we simply transfer the needed amount back into our checking account and use the amount for that expense. Very easy.

I should mention that during debt elimination, the type of sinking funds you have should be limited to the necessities. For the most part, you don’t need to focus on a family vacation or a new couch when your overarching financial goal is debt freedom. So limit sinking funds for things like quarterly and annual bills and necessities. When you’re debt-free, then you can start saving for the extra stuff.

And like I said, I think sinking funds are crucial especially during a season of debt reduction. The last thing you want to do is accrue more debt. With a Baby Emergency Fund of $1,000 and some basic sinking funds in place, it becomes so much easier to know exactly how much you can pile on your debt snowball.

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Personal Finance 101 – The Fully-Funded Emergency Fund

Tsh — Thu, 06 Mar 2008 11:55:43 +0000

This is the third part in my series on Dave Ramsey’s Baby Steps, a proven personal financial plan. My goal is to explain a really solid money management plan in plain ol’ English, for intelligent yet financially “average” home managers.

The third step with Dave Ramsey’s Total Money Makeover is to fully fund your emergency fund. This is probably the easiest step to understand, though it’s not the easiest to actually DO.

If you’re on Baby Step #3, this means you’re debt-free. And when you’re debt-free, it’s a lot easier to start spending money on the little things that really add up, be it worthwhile things like a family vacation. You write your monthly budget, and you don’t owe money to anyone, which means you see a lot more dollars on the income side. But don’t let it slip through your fingers. Pay yourself first. This will be your cushion between you and Murphy, your guarantee that you have absolutely zero excuse to ever take out debt again.

If you’ve been working the Baby Steps, and you paid off your debt using the debt snowball method, that means you can simply start putting the same amount of cash that you were giving to someone else and put it in your savings account instead. If you paid your last Visa payment in February to the tune of $500, just start redirecting that same $500 into your savings account come March. You’re already used to the same lifestyle on the same budget – just keep it up a little while longer and get that emergency fund nice and loaded.

Q: How much should I have in my Emergency Fund?

A: Take note – a fully-funded Emergency Fund should be 3-6 months of your living expenses, not your income. And it should probably be the expenses you’d deem important during a true emergency, not your everyday expenses when life is normal. Ask yourself what you’d pay when you were suddenly facing a job loss. You’re probably looking at your mortgage or rent, utilities, groceries, gas, internet service, and phone service (or just your cell phone). If you’re in the midst of a true emergency, you probably would cut out (or at least pare down) eating out, entertainment, major gift giving, and big purchases that aren’t life and death. That new dress can most likely wait until the emergency has passed.

With this info, let’s pretend using these low-end numbers:
mortgage – $800
utilities – $200
groceries – $300
gas – $150
internet service – $50
cell phone – $75
TOTAL = $1,575

$1,575 x 3 months = $4,725
$1,575 x 6 months = $9,450

With these numbers, you’re looking at somewhere between $5 to $10K. If these were my numbers, I’d play it safe and aim for an even $10,000. Remember that every household is different, so you know what’s important to you. Play with your numbers.

Q: What constitutes an emergency?
A: A job loss, major medical issues, a blown transmission, or some other unexpected event is an emergency. Christmas, prom dresses, and a weekend on the coast are not. It’s perfectly fine to save up for those things, but not in your Emergency Fund. Save for those separately, after your Emergency Fund is finished (this is called “sinking funds,” which I will write about soon).

Q: Where should I park my Emergency Fund?
A: It needs to be completely liquid, which means you need to have instant access to it. Dave says a basic savings account is fine. This is what we personally have – and we also figured we might as well get a decent interest rate while it’s sitting there. I did some research and learned about online banks – banks that have no traditional building, they only exist in cyberspace. If that sounds kinda scary, you’re not alone, but millions of people use internet banks, and since we started, we’ve never looked back.

Because they don’t have overhead fees, they can offer much higher interest rates than your standard brick-and-mortar institution. As an example, our “regular” credit union currently offers a rate of 0.69% on their savings accounts. Our internet bank currently offers 3.40% on their savings accounts – not enough to build wealth, but hey, might as well make money while we’re banking.

So where do we bank? We use ING Direct, which is renowned for its customer service. I’ve been amazed how easy it is to manage our accounts with them, so much so that it’s now our primary banking source. I highly recommend them. There are many reputable online banks – here’s a great resource for starting your research.

Q: How long will this take me?
A: It obviously depends on your interest rate and how much you can deposit monthly, but if you were able to save $1,000 in an ING savings account that earns 3.40%, you’ll reach $10,000 in nine months. Sounds like a chunk of time. It’s worth it, though. Just think – your emergency fund will be set! You can then start saving for some fun things, and except for those emergencies when you have to truly dip into that fund, you no longer have to set aside funds for a “rainy day.” You’ve already done it.

Here’s ING’s nifty little calculator to plug in your own numbers.

Missed other parts of my series?

photo credits: FastFords, redjar, Phil Moore, DJOtaku

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Personal Finance 101 – The Fully-Funded Emergency Fund is a post from Simple Mom