Everything About Sinking Fund: Meaning, Formula, Example and Types

Planning your dream vacation or clearing off a big debt without dipping into your emergency fund or taking another loan might seem unrealistic, but that is exactly what a sinking fund helps you achieve.

It is a smart, goal-based saving strategy that lets you set aside small amounts regularly for future expenses, so you are never caught off guard. For instance, saving just ₹5,000 a month can grow into ₹60,000 in a year, enough to fund a big goal, completely stress-free.

In this blog, we will explore what a sinking fund is, how it works, and why it deserves a spot in your financial planning toolkit.

Quick Synopsis 

• A safety fund to deal with planned future expenses by parking a fixed amount for a fixed tenure until the goal is achieved. 
• Recurring deposits or fixed deposits, and low-risk mutual funds are the best places to park your funds. 
• It helps to develop regular savings habits and prepares you to meet your larger financial requirements in future. 

What is Sinking Fund?

A sinking fund is a fund you create to cover significant expenses in future without applying for a loan or dipping into your emergency savings. Not only individuals but also corporations can create such funds to accumulate money for a specific purpose. At the individual level, you can create such funds to buy a new asset, renovate your home, or even repay debts. 

Sinking Fund Example and Formula

Understanding the sinking fund and its functioning would be better understood with an example. Let us dive into it. Assume that you are planning to buy a car in the next five years, and the total cost will be around ₹10 lakh. Instead of taking a loan or dipping into your emergency savings, you decide to set up a sinking fund. 

By saving ₹2 lakh each year, you will be able to purchase the car outright at the end of five years, without any financial stress.

By the way, have you ever wondered how much you need to save each year to reach a particular financial target? That is exactly what the sinking fund formula helps you determine. It calculates the precise annual amount you should set aside to meet a future goal, whether it is repaying a loan, buying a car, or replacing a major asset.

The formula is: S = (P × i) / [1 − (1 + i)^−n]​

Where:

S = Amount to be saved each year

P = Total value of the goal or debt

i = Interest rate

n = Number of years you plan to save

Example:

Let us understand this with an example. Suppose you have a loan of ₹5,00,000 that needs to be repaid in 10 years. You expect to earn a 5% annual return on your savings. Using the sinking fund formula, you will need to save approximately ₹65,145 every year. 

This ensures you can repay the loan comfortably at the end of the term, without taking on new debt or tapping into your emergency funds.

By following this disciplined approach, large financial goals become far more manageable and predictable.

Types of Sinking Funds 

Among several types of sinking funds, one is the Asset Replacement Fund. People prepare such funds when they need to replace any of their valuable assets. It can be a car, a laptop or any essential item. Scroll down to explore the other types!

Debt Repayment Fund

As the name suggests, this type of fund is created to repay debts, such as credit card outstanding balances, home or car loans. Calculate the periodic contribution amount using the sinking fund formula and pay off your debts on time.

Education Fund

Whether it’s to manage your child’s higher education costs, international education expenses, or your own further studies, an education sinking fund helps you handle these costs efficiently without having to apply for expensive education loans.

Emergency Fund

This type of sinking fund is built to deal with unforeseen situations. Whether to afford costly medical bills, home repairs or an unexpected unemployment period, it acts as a family’s safety cushion.

Callable Bond Sinking Fund

Corporations opt for these sinking funds to set aside a pool of money specifically to repurchase callable bonds before their maturity. 

Advantages of Investing in Sinking Fund 

One of the primary purposes of a sinking fund is to prepare for unpredictable future expenses. Here are some additional benefits:

1. Reduces Impulse Buying: By setting up a specific fund for future big expenses and remaining consistent regarding periodic contributions, you reduce the temptation to spend on unnecessary items. 
2. Reduced Financial Risks: As these funds help you accumulate a corpus aside, the risk of defaulting or being forced to enter into a new debt is greatly decreased. 
3. Generate Additional Income: Companies and individuals can park this corpus in a high-yield investment instrument, such as equity mutual funds, to earn potentially higher interest, creating an additional source of income. 

How to Start a Sinking Fund? 

You can start sinking funds by preparing these simple steps:

Step 1: Set a clear goal and understand what are you saving for? It could be for creating a retirement fund or buying a luxury car. 

Step 2: Determine how much and how long to save. You can use the simple formula mentioned above to calculate the periodic contribution. For instance, if you need ₹1,20,000 in 2 years, you need to set aside ₹5,000 every month. 

Step 3: Never and ever keep this amount at home or in your existing account. Create a separate account and park that money in this account every month.

Step 4: Set up the transfer tenure as per your convenience and make the process automated. This way, you never forget to contribute, making a good financial habit. 

Lastly, don't forget to track your progress periodically. It will help you stay motivated and ensure success.

Sinking Fund vs Savings Account 

Sinking Fund vs Emergency Fund 

A sinking fund may sound like something only big companies use to deal with huge future expenses, but it can be one of the most useful financial instruments if utilised properly. When considering where to park your sinking fund investment, you can opt for low-risk, fixed-income investment tools such as recurring deposits or fixed deposits. 

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