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?
A sinking fund is a financial strategy employed by organisations or individuals to save systematically over time for specific purposes, such as repaying a debt or replacing an asset. This fund is particularly relevant for assets like machinery, equipment, or vehicles that depreciate quickly and require renewal shortly after purchase. The process involves allocating resources consistently over an extended period to ensure adequate funds are available when needed.
Sinking funds are commonly associated with long-term obligations such as bonds, mortgages, or other significant loans. By adopting this approach, the entity avoids the financial strain of securing additional loans, which could lead to higher interest costs or other financial burdens. This proactive saving strategy fosters financial discipline and reduces dependency on external borrowing.
The primary objective of a sinking fund is to ensure financial readiness for future expenditures or liabilities, minimising potential disruptions to cash flow. Organisations often use sinking funds to reassure investors and creditors, demonstrating their commitment to meeting financial obligations responsibly. This practice not only mitigates risk but also enhances the entity’s financial stability and credibility.
In summary, a sinking fund serves as a vital tool for managing financial commitments effectively and avoiding unplanned debt, ensuring smooth financial operations over time.
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.
Sinking Fund Example
A sinking fund is commonly used by organisations and individuals for specific financial goals. For instance, consider a company that issues bonds worth Rs. 50 lakh, maturing in 10 years. Instead of paying the entire amount at the end of the term, the company sets up a sinking fund to gradually accumulate the required sum. It allocates Rs. 5 lakh annually into this fund, ensuring the full Rs. 50 lakh is available at maturity.
Similarly, for personal finance, imagine you plan to buy a car in five years for Rs. 10 lakh. By creating a sinking fund, you save Rs. 2 lakh annually, enabling you to purchase the car outright without needing a loan. This disciplined saving method helps you avoid borrowing costs like interest or the financial burden of a lump sum payment.
In both cases, the sinking fund provides a structured approach to meeting financial commitments without impacting other cash flow needs. It ensures preparedness for planned expenses, reduces financial stress, and eliminates the need for last-minute borrowing. Such funds are an essential tool for achieving financial stability and avoiding future debt.
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:
- 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.
- 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.
- 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.
- 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.
- 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.
