Sinking Funds: Defined & Explained

Key Takeaways


Maintaining a healthy savings account is important both for individuals and for businesses. If you anticipate significant expenses and plan accordingly, you’ll always have money to pay your bills. If you don’t, you’ll either have to sell some investments or forego the expense. If that expense is something major, like a big upgrade for your business, it could have substantial negative consequences.

So, what is a sinking fund, and what can it do to solve your problems? Sinking funds are a special kind of savings that are stocked away for major expenses like buying a new property. Here, we’ll talk about what a sinking fund is, why you might want one, and what it can do for your business. We’ll also provide a sinking fund example to tie everything together.

What Is a Sinking Fund?

For businesses, the most common use of a sinking fund is to set aside money to pay off a bond or other debt. Over the term of the bond, the company can slowly set aside money for repayment. That way, when the bonds mature, there’s no huge, lump-sum expense; the money has already been set aside. Along the same lines, a company may use a sinking fund to save for a planned investment, like a large property or a major facilities upgrade.
But sinking funds aren’t just for large corporations and big time investors – they can be used by anyone who wants to save up for a large, planned purchase. You can begin a sinking fund for a wide variety of reasons, including:

  • Vacation

  • Car purchases

  • Holiday expenses

  • School supplies

  • Home renovation

  • College loans

  • Wedding expenses

  • Down payment on a home

  • Property taxes

  • Property maintenance

  • Insurance premiums

  • Veterinary bills.

Sinking Fund vs. Savings Account

Before we talk about sinking funds in particular, let’s talk about the elephant in the room: why not just use an ordinary savings account? The difference is that a savings account is for general savings, while a sinking fund is set up for a particular purpose. Imagine you’re saving for a new car, your daughter’s wedding, a major vacation, and an elective knee surgery all at the same time. If you put all that money in the same account, you may soon find yourself robbing Peter to pay Paul. Using a sinking fund formula, you can allocate savings for each expense in its own separate account. That way, you know you won’t come up short.

Another similar type of account is an emergency fund, but there’s an important distinction here. Sinking funds are set up for known, planned expenses. Emergency funds, on the other hand, are set up for unknown, unplanned expenses. For example, let’s say your furnace dies in the middle of winter, and you need a replacement. You take the money from your emergency fund, install a new furnace, and replace the funds over time. Most financial advisors recommend keeping between three and six months of income in your emergency fund for an individual. But as wise as this is, it’s not the same as a sinking fund.


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what is a sinking fund

What Is The Purpose of a Sinking Fund?

The purpose of a sinking fund is to avoid the need for making any large, lump-sum payments for planned expenses. In the business context, this expense will usually take the form of company debt or a bond that has matured. The company will use a sinking fund calculator to determine how much money to set aside each month. That way, large debts can be handled as an ordinary monthly expense rather than a huge obstacle to overcome. Along the same lines, investors and companies can use these funds to cover multiple debts at once. You can make sinking fund deposits to various accounts in different amounts each month to cover those debts as needed.

Another reason companies might want to use a sinking fund is to improve their bond security. By having a sinking fund provision in place before issuing the bond, they can ensure investors that the bonds are safe and that the money will be there when they mature. Because interest rates are primarily based on risk, a safer bond commands less interest, which means the company has to pay back less in the long run by establishing a sinking fund to begin with. Not only that, but safer bonds will tend to attract more investors. If you need to raise a lot of money, you may have no choice but to establish a sinking fund to ease investor concerns.

Why Should I Start a Sinking Fund?

There are several benefits to establishing a sinking fund, particularly if you’re a company or investor with a lot of long-standing debt. This is the main reason most sinking funds are established. That said, there are a number of other sinking fund benefits, both for individuals and companies. Here are five excellent reasons to start a sinking fund today.

1. Avoid Interest Charges

One huge benefit of a sinking fund is that it can help you avoid taking on debt to begin with. If you’re already planning a major expense, you can save for it ahead of time instead of borrowing the money. This might seem like a lot of work for no benefit, but remember that debt comes with interest. If you take out a 30-year mortgage at a rate of 3%, you’re talking about thousands and thousands of dollars in interest. For expenses like weddings and vacations, or anything else you’d charge to a credit card, the interest can be more substantial. APR rates on cards routinely exceed 20%, which is a huge chunk of the money you’ve borrowed. By paying ahead of time, you’re avoiding significant interest payments in the future. Why pay more when you don’t have to?

2. Prevent Emergency Fund Usage

Another reason to establish a sinking fund is to avoid using your emergency fund. But wait, didn’t we just say that emergency funds are for unknown expenses? Yes, but there are unknown unknowns and known unknowns. An unknown unknown is something you really can’t plan for – for example, your company gets bought out, your position is eliminated, and you’re unemployed. A known unknown is something you can reasonably expect to happen – for example, if you’re a homeowner, you know your home will need some kind of repair at some point. You can use a sinking fund to cover these known unknowns (home repair, car repair, etc.) while keeping your emergency fund flush for the day you really need the money.

3. Limit Impulse Purchases

When people think of impulse purchases, they usually think about the small stuff – grabbing a candy bar in the grocery store checkout or buying a shirt because it’s on sale. But if you don’t have a set budget, you can just as easily find yourself spending more than you meant to for a house or a car. Sure, the hot rod might cost more than you meant to spend, but you qualify for the loan, so why not? With a sinking fund, you’re not taking out a loan, so you’re forced to stay within your budget.

4. Assist with Irregular Income

Not all businesses and individuals earn a steady income. You may be a contractor or a home builder who only gets paid when the job is done. You might be a freelancer with an income that fluctuates wildly from week to week. In this case, a sinking fund can be used to compensate. During profitable times, you put your excess cash into the fund. During leaner months, you can draw on that money to cover your day-to-day expenses. This is especially important if you have employees who expect to receive a steady paycheck.

5. Prepare for Anything

You never know how the markets are going to fare from month to month. You may be planning to finance a project, only to discover that the loan terms are no longer acceptable. The purchase price of a property may suddenly go up, so you can no longer afford it. If you’re depositing money regularly into a sinking fund, you’ll have excess cash on hand to cover these expenses. The same way you save for retirement and other long-term expenses, it also makes sense to save for shorter-term expenses.

How to Start a Sinking Fund

Starting a sinking fund is the same as starting a savings account, checking account, or other financial account. The process is very simple, at least from the perspective of opening the account. However, using the fund correctly requires you to budget in advance how much you’re going to deposit each month to meet your goals. Remember, if you’re not planning in advance, it’s not really a sinking fund.

Identify Savings Goal: Know what you’re saving for, and know how much you need to save. If you’re saving for a vacation, for example, price out the travel expenses and hotels ahead of time – and leave yourself some cushion since prices may change.

Choose Account Location: Normally, a sinking fund will require you to open a new account. This can be any kind of account, but be careful to watch out for monthly fees. If your account has a fee, it will eat away at your balance over time. Instead, opt for an account that’s easy to access and easy to use. Interest shouldn’t be a major consideration here. Savings account interest rates are so low these days that they amount to a rounding error on your balance.

Calculate How Much Needs to be Saved: Now, it’s time to decide how much to deposit every month or week. Let’s go back to our earlier example of saving for a vacation, and you’ve determined that you need to save $9,000 over the next 12 months. You would divide that by 12 months, and $9,000/12=$750. In other words, you need to deposit $750 per month to meet your $9,000 goal.

Establish Sinking Fund Within Monthly Budget: Any plan is only going to be successful if you follow through on it. Make sure that your sinking fund is factored into your monthly budget. Whether you’re using Excel, proprietary software, or a simple notebook, make sure to write it down and stick to it.

Sinking Fund Example

At the beginning, we promised to provide an excellent example of a sinking fund. Here it is: you own a fast-food franchise and want to buy another one. You need to float $100,000 in bonds, which will mature in 10 years, at a rate of 5%. This works out to just over $164,000 you’ll have to pay back when the bonds mature. To cover that, you establish a sinking fund to which you will deposit monthly for all 120 months the bonds are active. You know you need to pay $164,000, so you calculate $164,000/120=$1,366. Therefore, you deposit $1,366 into your sinking fund every month.

When the bonds mature, you have all the money you need to pay out, minus a few hundred dollars we rounded out of our equation. So instead of taking a $164,000 haircut in a single year, you spread that expense out over time, and it becomes just another budget line.

Summary

As you can see, a little bit of strategic saving can go a long way, whether you’re running a business or simply managing your personal finances. But if you’re not financially savvy, they can be intimidating. A sinking fund is the perfect way to make sure you are putting away the money you need to accomplish your long-term goals and that it will still be there when you need it.


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