Sinking Fund

What Is a Sinking Fund?

A sinking fund involves regularly depositing a specified sum, usually monthly or annually, into a savings or investment account. The objective is to accumulate enough funds to meet a future financial obligation, such as repaying a debt or replacing an asset.

Example (2025): Suppose you have a loan of ₹5,00,000 to be repaid in 10 years at an interest rate of 5 percent per annum. The sinking fund formula is as follows:

S = P × i / (1 - (1 + i)⁻ⁿ)

Where:

• P = ₹5,00,000 (Principal)

• i = 0.05 (Interest rate)

• n = 10 (Years)

Plugging in the values:

S = 5,00,000 × 0.05 / (1 - (1 + 0.05)⁻¹⁰) S = 25,000 / (1 - 0.6139) S = 25,000 / 0.3861 S ≈ ₹64,752 annually or ₹5,396 per month.

You would need to save approximately ₹64,752 annually to accumulate ₹5,00,000 in 10 years at 5 percent interest.

Key Components of a Sinking Fund

• Principal Amount (P): The total sum to be accumulated by the end of the term.

• Interest Rate (i): The annual rate of return on the sinking fund.

• Duration (n): The period over which the fund is accumulated.

• Regular Contribution (S): The fixed amount deposited periodically.

• Purpose: The specific financial obligation, such as debt repayment, asset replacement, or a major purchase.

Benefits of Sinking Funds

• Reduces Default Risk: Ensures that funds are available for significant financial obligations, reducing the risk of default.

• Improved Financial Planning: Avoids last-minute financial stress by spreading out the savings over time.

• Encourages Financial Discipline: Regular savings instill better money management habits.

• Flexibility: Can be tailored to various financial goals, such as loan repayment, equipment purchase, or even a vacation fund.

Challenges of Sinking Funds

• Opportunity Cost: The funds set aside may earn lower returns compared to higher-yield investments.

• Inflation Risk: If the fund’s returns are lower than the inflation rate, the accumulated sum may lose purchasing power.

• Consistent Saving Required: Maintaining regular contributions can be difficult, especially during financial hardships.

• Interest Rate Fluctuation: If the actual returns are lower than anticipated, the final amount may fall short of the target.

Conclusion

A sinking fund is a strategic financial tool that helps individuals and businesses prepare for future obligations without resorting to emergency loans or asset liquidation. In 2025, with interest rates fluctuating and inflation concerns rising, maintaining a sinking fund can provide a financial cushion for planned expenses. However, it is important to review the fund’s performance periodically and adjust contributions to account for changes in interest rates or inflation.