Sinking funds: Meaning, types, benefits, and formula

Imagine you have a large expense coming up, like a major car repair or a home renovation, and you don’t want to scramble for funds at the last minute. This kind of situation is precisely where sinking funds can be helpful. By systematically setting aside money over time, sinking funds help you handle significant expenses without dipping into your emergency reserves or racking up debt.

Whether you’re a seasoned investor or just starting your financial journey, learning about sinking fund investment strategies can add a layer of stability to your financial life.

• Table of contents

• What are sinking funds?
• Formula of sinking funds
• Sinking fund example
• Method to calculate sinking fund
• Types of sinking funds
• How to start a sinking fund?
• Benefits of investing in sinking funds
• How to create a sinking fund?
• Where should you keep your sinking funds?

What are sinking funds?

Sinking funds meaning: A sinking fund is a reserved pool of money set aside gradually to meet a future liability or expense. Historically, corporations used sinking funds to repay bonds or debt. Nowadays, individuals also employ sinking funds for various personal finance goals, such as:

• Paying off loans
• Funding a big purchase (car, home, vacation)
• Covering irregular expenses (property taxes, annual insurance premiums)

In essence, the concept is straightforward: instead of waiting for a massive bill at once, you set aside smaller amounts periodically, allowing the fund to “sink” the future expense when it arrives.

While the term sinking mutual funds is not commonly used in personal finance, some mutual fund strategies may be set up to help investors build capital to meet a known future expense. However, traditionally, a sinking fund is a separate savings or investment account rather than a specific type of mutual fund.

Formula of sinking funds

When thinking of a sinking fund formula, it’s typically about determining how much you need to contribute regularly to meet a target amount in the future.

Here’s the technical approach:

Periodic Contribution = FV / [((1 + r)^n - 1) / r]

Where:

• FV (Future Value): The total amount you need at the end of the period (e.g., the lump sum to pay off a loan or meet a big expense).
• r: The interest rate per contribution period (for example, monthly or quarterly etc.).
• n: The total number of contribution periods.

This formula is similar to the one used for computing payments into an annuity. It helps you break down a lump sum target into manageable periodic contributions that account for potential investment growth (or interest earned).

Sinking fund example

Let’s look at a sinking fund example to see how it works:

• Goal: You want to have Rs. 1.2 lakh ready in 12 months to pay annual property tax.
• Approach: You decide to put Rs. 10,000 aside every month into a separate account.
• Result: By month 12, you’ll have the corpus you need.

No surprises, no last-minute borrowing. In this simple example, you’re not factoring in interest, but if you choose a savings or investment account that yields returns, you might need to set aside slightly less each month to reach the same goal, thanks to compounding interest.

Method to calculate sinking fund

There are two main ways to calculate how much you should contribute to your sinking fund:

• Without interest: Simply divide your target amount by the number of months until you need the money. For instance, if your goal is Rs. 1.2 lakh in 12 months, that works out to Rs.10,000 per month.
• With interest: Use the sinking fund formula mentioned earlier. This method factors in the returns you might earn if you keep your sinking fund in an interest-bearing account or investment vehicle.

Choose the calculation method that aligns with whether you’re saving in a zero-interest environment (like storing cash at home) or a higher-yield savings or investment account.

Types of sinking funds

Sinking funds aren’t only for paying off debt. They can be structured for various financial scenarios:

• Debt repayment: Commonly used by corporations to manage bond obligations over time. Individuals can also use this approach to pay off personal loans or credit card balances systematically.
• Capital expenditure: Save gradually for big-ticket items such as cars, electronic gadgets, or home renovations. Sinking funds can help you avoid taking out new loans or using high-interest credit.
• Emergency or contingency: Separate from a primary emergency fund, a sinking fund can be allocated for predictable but irregular costs (like car insurance, medical check-ups, etc.).
• Annual payments: For expenses like property taxes or annual subscriptions, you can break down the cost monthly so that it’s more manageable when the due date arrives.
• Periodic events: Weddings, birthdays, and festivals often come with hefty bills. A sinking fund can smooth out the financial burden over time.

How to start a sinking fund?

• Identify the goal: Decide what expense or liability you’re preparing for—be specific about the target amount and timeline.
• Choose your method: Determine whether you’ll use the plain division method or the sinking fund formula that includes interest.
• Set up a separate account: Keep the funds away from your primary checking or emergency account to avoid mixing and accidental spending.
• Automate contributions: Schedule automatic transfers or use a standing instruction to ensure consistency.
• Monitor progress: Track your balance and update your contributions if your goals or interest rates change.

Benefits of investing in sinking funds

• Debt management: It provides a structured way to pay back loans, avoiding the shock of large lump-sum payments.
• Stress reduction: Knowing you have a plan for upcoming expenses can relieve financial anxiety.
• Avoid high-interest debt: By saving in advance, you can steer clear of credit card debt or personal loans.
• Better cash flow: Spreading out expenses over time helps maintain stable monthly budgets.
• Potential returns: If you opt for a suitable investment vehicle, your contributions can earn returns.

How to create a sinking fund?

• Determine the lumpsum you need and the exact date you’ll need it by.
• Break it down into monthly (or weekly) contributions.
• Decide on where you will stash these contributions—whether it’s a savings account, a recurring deposit, or another stable investment channel.
• Automate your contributions to ensure consistency and reduce the likelihood of skipping payments.
• Periodically review your sinking fund to confirm you’re on track and adjust the contributions if needed (for example, if your investment returns are higher or lower than expected).

Where should you keep your sinking funds?

The location for your sinking fund investment depends on your time horizon and risk tolerance:

• High-yield savings account: If your goal is short-term (within a year or two), a savings account or short-term deposit can be a prudent choice.
• Recurring deposits or fixed deposits (FDs): For medium-term goals (1-5 years), recurring deposits can offer slightly better interest rates. Fixed deposits might lock your funds, so ensure your timeline matches the FD duration.
• Debt mutual funds or liquid funds: For a slightly longer duration or higher risk appetite, certain debt or liquid funds can offer a better return potential than a standard bank account but be mindful of market fluctuations, as mutual funds are subject to market risk.
• Equity mutual funds: If your sinking fund has a longer horizon (5 years or more) and you’re willing to accept some level of market risk, you could consider a conservative equity or hybrid mutual fund. However, be aware that short-term market volatility can impact your investments.

Ensure you choose an option that aligns with your timeline and comfort level. Remember that the primary purpose of a sinking fund is to have money available when you need it, so don’t take on undue risk for short-term goals.

Conclusion

Sinking funds bring order and predictability to your finances by helping you plan for upcoming liabilities or expenses—without falling into debt traps. By grasping the sinking fund formula, evaluating different types of sinking funds, and consistently contributing to your chosen account, you can manage big expenses with ease. Whether you’re aiming to pay off a debt or save for a special event, the discipline and flexibility offered by sinking funds make them an invaluable addition to any financial toolkit.

FAQs:

Is sinking fund a cash fund?

A sinking fund is essentially a pool of cash set aside for a specific purpose. It doesn’t have to be in physical cash; it can be in a savings account, fixed deposit, or low-risk investment instrument. The key is that the money is accessible when you need it.

Is sinking fund compulsory?

In personal finance, a sinking fund isn’t mandatory, but it may be recommended for better financial planning. In corporate finance, companies may be required to maintain a sinking fund for certain bonds to reduce default risk.

What is sinking fund formula?

A simplified version involves dividing the total amount needed by the number of periods until the expense. A more precise approach uses an annuity formula:

Periodic Contribution = FV / [((1 + r)^n - 1) / r]

This factors in interest rates and compounding.

Why do they call it a sinking fund?

The term “sinking” historically referred to how the fund “sinks” (or gradually pays off) a debt or obligation. Over time, the contributions metaphorically reduce—or sink—the outstanding financial liability.

What is a sinking fund example?

A straightforward example is saving Rs. 1.2 lakh over 12 months to cover annual property taxes. You’d simply deposit Rs. 10,000 every month into a separate account until you reach the total sum.

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