Definition
A sinking fund is a strategic financial account specifically set aside to add up savings over time for a particular, frequently anticipated, future expense. By making regular deposits into this account, and taking advantage of compound interest, the fund incrementally grows to a predetermined amount by the end of a stated period.
A sinking fund can be particularly beneficial in real estate for accumulating monies for significant one-time expenses such as home down payments, major repairs, or property tax payments.
Examples
Example 1: Saving for a Down Payment
The Johnson family plans to purchase a home three years from now. They estimate needing $5,000 for a down payment. To achieve this, they set up a sinking fund that offers 5% annual interest. They deposit $129 monthly into the fund. After 36 monthly deposits and the accrued interest, the fund will contain the required $5,000.
Example 2: Property Upgrades
An apartment complex owner projects needing $50,000 for major renovations in five years. He establishes a sinking fund with an expected annual return of 4%. This necessitates a monthly input of around $780. Continual deposits and compounding will ensure reaching the $50,000 target by the end of the fifth year.
Frequently Asked Questions (FAQs)
What is the primary purpose of a sinking fund?
The primary purpose of a sinking fund is to systematically save money for a future expense, spread out over time, ensuring that the needed funds are available when the expense occurs.
How is a sinking fund different from regular savings?
A sinking fund is targeted savings with a designated purpose and timeframe, whereas regular savings might not have a specific goal or deadline.
Can the contribution amount vary in a sinking fund?
Yes, contributions can vary depending on changes in financial circumstances, but maintaining a consistent contribution level helps ensure the goal is met within the expected time.
Is the interest earned on a sinking fund taxed?
Yes, the interest earned on a sinking fund is typically subject to taxation, and the specific taxation rules can depend on your country’s tax laws.
How do you calculate the necessary deposit amount for a sinking fund?
To calculate regular deposits for a sinking fund, use the future value of an annuity formula, considering factors like the total target amount, time period, and interest rate.
Related Terms
Compound Interest
The interest on a loan or deposit calculated based on both the initial principal and the accumulated interest from previous periods.
Annuity
A series of equal payments made at regular intervals. Sinking funds can often utilize annuity formulas to plan deposits.
Down Payment
An upfront part of the total purchase price paid when acquiring a property, usually expressed as a percentage of the total price.
Future Value
The value of a current asset at a specified date in the future based on an assumed rate of growth.
Online Resources
- Investopedia: Detailed guides on various financial strategies including sinking funds Investopedia.
- Bankrate: Provides tools and calculators to plan for various financial goals. Bankrate.
References
- PwC Corporate Finance, “Using Sinking Funds for Loan Repayments,” pwc.com
- U.S. Department of Treasury, “Savings Bonds and Sinking Fund Provision,” treasury.gov
Suggested Books for Further Studies
- “A Random Walk Down Wall Street” by Burton G. Malkiel
- “The Intelligent Investor” by Benjamin Graham
- “Your Money or Your Life” by Vicki Robin and Joe Dominguez
