What are Sinking Funds?
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For Indvidual’s, businesses or governments managing money is a major part of financial planning. The appropriate financial tool will help to achieve long-term goals without financial strain. In this process, sinking funds play a vital role in planning future expenses or debt repayment.
In this blog we explore sinking fund meaning, examples, sinking fund calculation, their benefits and how they differ from savings funds.
What is a Sinking Fund?
A sinking fund is a special fund that is created to set aside money over time for a purpose, usually a large future expense or debt repayment. Instead of bearing large amounts, by using this technique you can contribute smaller amounts regularly into a sinking fund to fulfil the need.
In simple terms, sinking funds helps you “sink” money gradually into a dedicated fund so that when the time comes, you’re financially ready.
Sinking Funds Examples
Understanding sinking funds example will help you see how useful they are in your personal and professional life. Here are some examples of sinking funds;
🠖 Personal Use
Savings for vacation, annual insurance premium, car maintenance, etc.
🠖 Municipal Debts
Repayment of municipal bonds.
🠖 Mutual Funds
Mutual funds in India uses sinking funds that will help to fulfil individuals’ commitments.
🠖 Real Estate
Some housing societies maintain a sinking fund for major building repairs or renovations.
🠖 Infrastructure Projects
It is set to cover future expenses like maintenance, repairs, and replacement of assets.
How is the Sinking Fund Calculation done?
The sinking fund calculation is based on how much money you need to set aside regularly to reach your target amount.
You can use the formula;
S = (P * i) / (1 – (1 + i)^-n)
Where;
S = Periodic payment needed for a sinking fund
P = The total amount needed at the end of the period or target amount
I = Interest rate/annual rate divided by the number of periods per year
N = Total number of periods
The formula will help you to find out how much you need to contribute each period to meet your goals.
Sinking Fund Methods
There are a few sinking fund methods used to calculate contributions based on the scenario:
| Methods | Definition |
| Fixed Installment Method | Equal amounts are deposited regularly, assuming a constant interest rate |
| Reducing Balance Method | Contributions vary as per the remaining balance or changes in interest |
| Annuity Method | Popular for debt repayments, this calculates equal periodic deposits needed to reach a fixed amount |
| Straight Line Method | Used in accounting, this method spreads cost evenly across a period |
Different Types of Sinking Funds
There are various types of sinking funds, they are listed below;
Debt Sinking Fund
It is mostly used by corporations to repay their bonds. And some individuals also use this approach to pay back their personal loans and credit card balances.
Annual Payments
The annual expenses like property taxes or annual subscriptions, you have to break down the monthly cost to manage them.
Emergency Sinking Fund
It’s like a backup for planned but large expenses, it includes; car insurance, medical check-ups, etc.
Periodic Events
Like weddings, festivals, birthdays that will receive heavy bills, so if you sinking funds in advance will smoothen the process.
Capital Expenditure
The sinking of funds to fulfil big tickets like buying a car, home renovations etc. will help to avoid taking out new loans.
Education Fund
To avoid expensive education loans, you can start an education sinking fund for your children’s future study expenses.
Benefits of Investing in Sinking Fund
🠖 The fund will save money for occasional costs like insurance premiums, studies, weddings, etc.
🠖 It will reduce the stress of individuals because you have already set a plan for the upcoming expenses.
🠖 Avoid borrowing money and the use of credit cards, because these will lead you to debt.
🠖 You may get interest from your funds by saving money.
🠖 It also encourages regular saving habits for both individuals and organizations.
Drawbacks of Investing in Sinking Funds
🠖 The fund is tied to a specific goal, so the usage of funds is restricted.
🠖 The saving for the significant cost will take time, so you have to wait patiently.
🠖 If you aren’t properly invested, your money may lose value over time.
🠖 Requires planning to forecast future expenses accurately.
🠖 If the fund is in low-risk options like savings account, the returns may be minimal.
How to Start a Sinking Fund?
Step 1: Identify the Goal
Take a decision first, for what expense or liability you’re preparing to save money, it’s about the target amount and the deadline.
Step 2: Set the Target Amount
How much will it cost? For example, if you need 1,20,000 within one year you have to save 10,000 each month.
Step 3: Open a Separate Account
You must open a separate account with the sinking fund, otherwise you will accidentally take funds for your daily expenses.
Step 4: Set a Deadline and Frequency
Setting a deadline means when do you need the money? And also choose the frequency of contributions like monthly, weekly or quarterly.
Step 5: Automate Contributions
Set-up automatic contributions that will ensure consistency as per your given frequency.
Step 6: Track Your Progress
Check once a month to track your progress.
Sinking Fund Vs. Savings Account and Emergency Fund
| Feature | Sinking Fund | Savings Account | Emergency Fund |
| Purpose | Specific goal-based | General savings | Unpredictable events |
| Access | Limited until goal is reached | Flexible anytime | Flexible anytime |
| Tracking | Goal-specific | Not always goal-specific | Save for unpredictable events |
| Interest Rate | Depends on investment | Lower | Lower |
| Discipline | Structured saving to a specific goal | Not following disciplined saving habits | Not following disciplined saving habits |
| Risk | Low risk | Low risk depends on the bank’s terms | Low risk depends on the bank’s terms |
| Example | Home renovation, car service, etc. | Marriage, children’s education, etc. | Medical emergencies, job loss, etc. |
Conclusion
Sinking funds is a disciplined way to plan your future expenses without financial stress. If you are saving money for a vacation, a new gadget or bond repayment by choosing this method will make you prepared without disrupting your day-to-day finances. So, your small amount savings will avoid large one-time expenses easily.
Should we make changes to your regular financial management system through sinking funds? Navia Markets has the best team waiting to assist you!
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Frequently Asked Questions
What is an example of a sinking fund?
Saving ₹2,000 monthly for 12 months to pay for a ₹24,000 annual insurance premium is a perfect example.
Why is it called sinking funds?
The term “sinking” refers to gradually setting aside money to “sink” or reducing a future financial burden, like debt or a large expense.
Are sinking funds risky?
Not usually. It’s considered low risk since it’s meant for planned expenses and often kept in secure accounts.
Who pays the sinking fund?
The fund is created and funded by the individual or company planning for future expenses.
Is a sinking fund good?
Yes. It’s excellent for financial discipline, future readiness, and reducing reliance on debt.
How to calculate a sinking fund?
Use the formula:
S = (P * i) / (1 – (1 + i)^-n)
Or simply divide your total goal by the number of months left.
Is a sinking fund a loan?
No. A sinking fund is not a loan. It’s your own savings set aside for a specific goal.
How to track sinking funds?
Open separate bank accounts to track each goal-specific fund.
DISCLAIMER: Investments in the securities market are subject to market risks, read all the related documents carefully before investing. The securities quoted are exemplary and are not recommendatory. Brokerage will not exceed the SEBI prescribed limit.
