Sinking Funds - Meaning, Formula, Examples and How to Calculate (2024)

A sinking fund is a fund used to set aside money over time for a specific future expense. It involves regularly depositing a fixed amount of money into a separate savings account or financial instrument. A sinking fund is established to cover unforeseen major expenses, helping to avoid the need for loans or immediate out-of-pocket payments. This essay is going to explain what a sinking fund is, identify types of sinking funds, and explain its source of establishment.

What are sinking funds?

Sinking fund refers to a fund established by an economic entity by ensuring enough money saved over a long period to pay a debt or replace an asset. Assets may include machinery, equipment or vehicles that rapidly depreciate and need renewal shortly after purchase. This method involves long-term debts such as bonds, mortgages or loans. This method is centred on saving up money over time until it is needed to pay a debt or replace the asset. The reason is to avoid taking another loan, which may result in extra interest or other financial consequences.

Formula of Sinking funds

The sinking fund formula will identify how much you need to set aside every year to accumulate a certain amount over time. It is particularly helpful if you have a debt or an asset that needs to be paid or replaced in a few years.

The formula looks like this:

S = (P * i) / (1 - (1 + i)^-n)

Where S – the amount that needs to be saved every year; P- the entire amount that should be paid off or the cost of the asset today; i – interest rate; n – how many years you will keep this saving. For instance, if you have a loan of Rs. 500,000, which needs to be paid in 10 years and the interest is 5%, then according to the sinking fund formula, your yearly saving should be Rs. 65,145. It means that you need to save approximately Rs. 65,145 every year for 10 years to be able to pay the loan. This approach allows saving on a constant basis for a large payment and minimises the necessity to apply for another loan or suddenly use one’s savings.

Sinking funds offer investors exposure to money that is set aside which can be used in times of need, providing opportunities for both SIP investment, allowing regular contributions, and lumpsum investments , enabling one-time allocations, catering to varying investment preferences and goals.

Method to calculate Sinking fund

Regarding the sinking fund method, it is a good way to manage the payment of debts that have accumulated over many years and need to be paid at the same time or replacement assets. Initially, a sinking fund is created and a fixed amount of money is allocated to it every set period. Over time, this pool of money will become larger, and then there are available funds to pay an old debt or replace the asset. Every year you allocate a certain amount of money to a sinking fund. After 20 years, you have money that allows you to pay off the remaining debt and not take a new loan.

Types of sinking funds

Sinking funds can be used for various purposes, each tailored to different financial needs. Here are some common types:

1. Debt repayment sinking fund: This is set up to pay off long-term debts like mortgages, car loans, or credit card debts. By saving a little at a time in this fund, you can gather enough money to clear the debt when it's due, helping you avoid additional borrowing or high interest rates.
2. Asset replacement sinking fund: This fund is for replacing assets like cars, machinery, or equipment. Regular contributions help you save up to buy a new asset outright when the old one needs replacing, avoiding the need for loans or using up your savings.
3. Emergency fund: This is designed to cover unexpected expenses such as medical emergencies, home repairs, or urgent car fixes. By putting money into an emergency fund regularly, you can handle these surprises financially without needing to borrow or use credit.
4. Education fund: This fund helps save for educational expenses like college tuition, books, and other fees. Regular savings can build a fund that covers these costs, reducing dependence on loans or scholarships.
5. Retirement fund: Aimed at saving for retirement, this fund ensures you have enough to support yourself later in life without relying solely on Social Security or other government benefits. Regular contributions build a substantial nest egg over time. You can also invest in retirement mutual funds for to create a retirement fund.
   

How to start a sinking fund?

Starting a sinking fund is a straightforward way to reach your financial targets. Here's how to do it:

1. Set your goal: First, decide what you're saving for, whether it's to pay off debt, replace an asset, or cover a future expense. Figure out how much money you'll need and the deadline to achieve this goal.
2. Determine your contributions: Next, calculate how much you need to save regularly. You can use the sinking fund formula, which considers the interest rate, how many times you'll make payments, and the current value of what you're saving for.
3. Open a separate account: To ensure you don't spend the sinking fund on other things, open a dedicated account for it. This keeps your sinking fund money separate from your regular spending.
4. Make regular contributions: With your account set up, start making regular contributions. This could be weekly, monthly, or quarterly, depending on what suits your budget and financial plan best.
5. Track your progress: Keep an eye on your savings. Check regularly to make sure you're on track to meet your goal and adjust if necessary. This will help you stay motivated and make any needed changes along the way.
   

Benefits of investing in sinking funds

Sinking funds are a practical financial tool that offer several benefits:

1. Avoid debt: By saving bit by bit for large expenses, sinking funds help you avoid taking on debt. This means you won’t have to pay interest on loans or credit cards for big purchases or bills.
2. Reduced financial stress: Knowing you have money set aside for future expenses can reduce anxiety about how you'll cover them. This makes financial surprises more manageable.
3. Helps in budgeting: Sinking funds require you to plan and set aside money regularly, which improves your overall budgeting skills. This disciplined approach can enhance your ability to manage money.
4. Ensures timely payments: Whether it’s for a tax bill, insurance premium, or a mortgage repayment, sinking funds ensure you have the necessary funds when these large payments are due.
5. Flexibility: You can start a sinking fund for nearly any purpose, from holiday gifts and vacations to home repairs and vehicle maintenance. This flexibility allows you to prepare financially for any aspect of your life.

Overall, sinking funds can be a powerful way to handle your finances, giving you more control over your spending and saving.

Conclusion

A sinking fund is a financial strategy designed to help you save for future expenses. Depending on what you're saving for, there are different types of sinking funds to cover various needs. Setting up a sinking fund is easy. It involves a few clear steps: define what financial goal you want to achieve, calculate how much money you need to save regularly, open a dedicated account for this fund, consistently contribute to it, and keep track of your savings progress. By doing this, you can meet your financial targets without having to borrow money or dip into other savings when expenses come up.

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