Needed: A sinking fund for expenses

It ensures that you don’t mess up the monthly budget

Most readers would be familiar with the concept of an emergency fund, but few would perhaps know about a sinking fund, much less have one. But keeping aside a part of your monthly income to set up this fund will put you in much better control of your finances.

Fund your predictable expenses: Sinking fund is the money we keep aside for predictable expenses that are not incurred monthly but may come at a date in the future. In the case of some expenses, we expect them but don’t know when they will arise. Says Mumbai-based certified financial planner Pankaj Mathpal: "A sinking fund is simply a strategic way to save money by setting a little bit aside each month. For instance, in a humid place like Mumbai, the air conditioner needs to be replaced every fourth or fifth year. If you are lucky, it may last longer. You don't know the exact day, but it has to be replaced someday in the future. Maybe you want to renovate your house every three or five years to keep up with your family’s changing needs." Planning for Diwali expenses or the yearly visit to your hometown can also be done using a sinking fund.

Even out cash outflows: By setting aside a little bit each month, you can spend big without hurting your cash flows. Says Mrin Agarwal, financial educator and director, Finsafe India: "The cost gets 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 ~24,000 coming every November, instead of taking a huge chunk out of your October salary or using your credit card, save a little in a sinking fund every month so that you can pay the lump sum in November without too much stress.

Not the same as 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. According to Mumbai-based certified financial planner Kiran Telang, "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."

May invest in less liquid assets: Do not use your savings account to set up a sinking fund. Says Agarwal: "Since the money is easily accessible, you could divert the funds to meet other needs. Also, it hardly gives any return." Mathpal, too, is of the view that assets in a sinking fund should not be very liquid. “I am not saying they should be in an illiquid instrument like Public Provident Fund (PPF), but they should not be as liquid as an emergency fund either. Here, you need some liquidity, but you must also earn decent returns."

To set up a sinking fund, some planners suggest just increasing the amount being invested via systematic investment plans (SIPS) to set up an emergency fund. Says Telang: "To keep the two types of funds separate, you may have separate

SIPS. Those in low tax brackets may use recurring deposits to set up a sinking fund, while others may start an SIP in a debt mutual fund." The instruments used can also vary depending on your time horizon. Says Mathpal: "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 funds work well."

Use best estimates: For things like a vacation or home renovation, it's easy to estimate the cost. Divide the amount by the number of months left until you plan to use the fund, and set up an SIP accordingly. Expenses on gadget repair or replacement, yearly dental work, or car maintenance can, however, vary. Says Telang: "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 a part of the expense will get covered."

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

If the cost of repairing a gadget is 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. Says Telang: "For gadgets, you can put aside ~5,000-10,000 as SIP, since every year something or the other breaks, needs repairs or renovation."