Sinking fund formula & categories (Examples)

Sinking fund, at first seeing the word, what comes to your mind?

A fund that is sinking formula?

Honestly the very day I heard the word was in my corporate finance lecture hall and it really sounds weird to me.

After the lecture, I found out that I was simply being plain stupid or will I say foolish.

The truth is, most of us do a sinking fund without knowing it at all. After reading this article, you got to know what the finance term is all about.

I will be explaining sinking fund categories which will be of good help to your personal savings, and also gives a good sinking fund example.

First, let’s understand what the term means.

What is a sinking fund

Sinking funds are mostly associated with bond issues and they usually specify the minimum amount of bonds to be retired yearly.

What is a sinking fund?

This is a specified fund or money put aside in each year, in order to provide for all the retirement of a bond or any asset replacement as the case may be.

To make it easier for everyone to understand, a sinking fund is a savings or money put aside for expenses that may come up. Mind you this is different from an emergency fund which is usually expenses made in an unforeseen circumstance.

Each week or month you’re setting aside a sum amount of money for expenses you know that will eventually happen, be it in six months’ time or at the end of the year.

A typical sinking fund example is car repair for those that own a car. You know that there’s no way you will ride your car for a whole year without servicing your car.

So using the sinking fund method, on a weekly or monthly basis, you set aside a certain amount of money for your car repair.

You can set up three to five different sinking fund for the different expenses that you know will definitely occur. Whereas, it must involve having or opening a five different bank account.

What is the purpose of a sinking funds

The major purpose of having such a savings account is to enable you to gradually save money for those expenses you know that may be too much for you to pay at once.

You set out a certain sum amount of money on every paycheck you receive for the different expenses or assets.

Let me give a sinking fund example.

You have bad eyesight, and which requires that you visit the doctor at least twice in a year and you don’t have health insurance that covers it.

You may visit the doctor and you’ll be required to undergo new eye refraction as you need new glasses. At that very point in time, you may not have the money to pay for the refraction and for the glasses, which may even have you go out to look for funds.

However, if you have been saving money bit by bit and until the time to go for your eye check-up, you will not find yourself in such a situation.

Another sinking fund example includes birthday gifts.

This may not be necessary for some people, but it does in my house.

I remembered when my mum was going on 60 and which should be celebrated. What I did is to open a sinking fund account as I’ve already planned the type of gift I will present to her on that very day.

And the gift is a very costly one I must say.

I set out the amount I will be deposited into the account on monthly basis and multiplied it by ten as her birthday is in the month of October.

As we entered the new year, I started saving money for that very gift.

Each month I remove the said amount from my salary and deposit it into the sinking fund account (I opened a bank account for it). Few days to her birthday, I already saved the total amount required in buying that very gift.

While making the order, the price was reduced by almost $120 and I had my gain at the end.

So the purpose of a sinking fund factor is to help save money for expenses or assets that you know will definitely come up and doing so bit by bit.

Nothing is more painful than having expenses piled up at year-end and you don’t have money to pay for all them.

Honestly having this type of account helps you not to go into debt.

How to create the account

sinking fund example

Before going ahead to do this, there are certain questions you need to ask yourself and also answer the questions.

They are?

What are the expenses in your household that require having a sinking fund account?

Should I open a single account for each expense or asset?

How much will be put aside or depositing into the accounts?

How many months should I do in a year?

1. Listing out your household expenses 

Each household expenses varies, mine will be different from yours. This is why you need to think and go through all the household expenses you pay once or twice a year.

Kindly note that these expenses require bulk money. 

Please this type of money-saving isn’t for that asset that you’re required to pay $50 or even $120 per six month months or in a year.

The assets or expenses I’m talking about are those that require you to pay $1,000 or $10,000 and above in six months or in a single year.

Though everything depends on one’s income and expenses.

Having listed all the assets in your household that involves high yearly payments, next is to determine the amount to set aside.

2. How much should I set aside? 

The first question you need to answer is, are you paid weekly or monthly?

And how much are you paid?

If you’re paid on weekly basis, on each paycheck you should set aside money for the sinking fund. While if you’re paid on monthly basis, I recommend you do that every month end or immediately you received your salary.

Let’s say your salary is $20,000 and you’ve three major assets that require a yearly payment of $2000 each and this totals $6000 for the three items.

In order to make the payment easier for you at the due date, on each monthly paycheck you will be setting aside $167 or to round it up to $170 each month on the three different sinking fund accounts.

This totals $500 which you need each month in order to pay for the total $6000 for the three-item. This really eases the stress and panic of paying the bulk money from a single paycheck.

3. Opening a sinking fund account 

I’ve some people ask if it is proper to open a bank account for this or even open multiple accounts.

This is how I do mine and it has been working for me.

I opened two main accounts, one for an emergency fund, while the other is for sinking funds.

At the start of each year, I will list out all the major items in my house that require a huge amount of payment at year-end or maybe every six months.

I will calculate the total amount I will pay for the items and ascertain the amount I need to put aside from each monthly paycheck.

At every paycheck, I will deposit the total amount for the items I concluded I will be setting aside on each monthly paycheck into my sinking fund account which is actually a savings account.

But you can make it a lot easier by opening multiple savings account for each of your major items like bills, car repairs, vacation, etc.

If you don’t fancy opening a bank account, you can equally make such savings right inside your house by using money safe.

Sinking fund formula

I equally use this but at times get so tempted to open the safe and use the money inside.

So if you can endure, I strongly recommend buying money safe for all your major or essential sinking fund factor.

If you decide to go for a bank account (Savings account) I advise you not to request a debit or credit card. You might get tempted on making withdrawals from the savings account.

Sinking Fund Categories

This is an insight on some of the items that require opening a sinking fund account, though it varies from individual to individual.

However, some the sinking fund categories affect the general public and the include the followings;

MEDICAL FUND:

If you’re the type that hardly falls sick or can go for ten years without falling sick, that good for you.

However, it shouldn’t be the reason why you’re not saving for your medical bills. One major sickness may fall you and which requires lots of money for treatment.

If you’ve not been saving such or probably don’t have the money, you’ll be running hector and Schecter looking for the fund.

Having savings for medical is very essential and if you have poor eyesight like me, having a sinking fund account is just cause you to need to visit the doctor at least twice in a year.

HOME FUNDS 

The home funds include paying off bills or utility bills, furniture repairs, or changing of old worn out the home furniture, taxes, and insurance, car repairs, etc.

This comes in handy in paying off utility bills.

You’re to pay for a yearly utility bill of $2000 at the end or start of the year. It is good to plan towards it and having a sinking fund account helps you lot in paying for such bills without stress.

What about car repairs and services? 

If you have a car, you must service it at least three times a year in order to properly maintain it.

Not only that, what of renewing your driver’s license or insurance? That is pretty much compulsory and should also be included in your home sinking fund account.

EVENT FUNDS

This includes having a birthday party, planning and funding for your wedding, or celebrating Christmas in a big special way which includes Christmas gifts.

Every 25th of December is a big party in my house right from childhood and right now I’m older, I love to celebrate it in a big way.

This requires buying lots of quality gifts for my family and preparing a special meal on that very day.

I work towards achieving that starting from the month of January to November.

This saves me a lot from panic buy or buying for things I don’t really value that much because I don’t have the money to afford the quality ones.

This particular sinking fund categories differ from person to person.

PERSONAL FUNDS 

This is very essential and important as an adult, your personal needs.

What are your personal needs in a given year?

Do you want to buy a new car?

Go to a new apartment or build a house without a mortgage?

Buy new clothes and shoes with jewelry?

Or maybe you’re planning on getting the upcoming iPhone or Samsung note.

Opening a sinking fund account will help you to achieve that your very dream, especially if you’re determined to achieve your dream goal.

TRAVEL FUND 

What can be a lot sweeter than going on a family vacation?

OH no, I’m so pissed off as I don’t have money to go for a vacation and my kids are bothering me with that.

To succeed in this life, you need to work and plan.

Unless you earn a very fat salary or wage that you can suddenly decide to go on a vacation without planning and working towards that.

You want to visit the Caribbean, you have to plan and work towards achieving that. Having a sinking fund account for your family vacation will be of huge help to you succeeding in achieving that dream.

PETS FUNDS 

This type of sinking fund categories is essential for those that have pet or pets in their homes. Well, this includes home funds but I decided to separate it from home funds.

Pet funds include feeding, medical checks by visiting a veterinarian.

EDUCATION FUNDS 

sinking fund categories

The education fund is essential for your child’s education, this will even include going to the university or college.

My parents saw my education from nursery to university level. They really worked towards that especially for me going to the university (college).

For my parents doing this for me, I will also do it for my kid(a) when I have one.

You can start funding for your child’s education by opening a Children’s savings account, high yield savings accounts or you can as well use the sinking fund account.

It really helps a lot in paying for your kid’s tuition or fees without going through stress in order to pay for kids’ fees.

There are lots of sinking fund categories and it depends on one’s priority in life, definitely, mine will be different from yours.

Now it is time for formula and calculation. This will be of huge help if you’re a finance student.

Sinking fund formula

Since the sum set aside are invested with interest element in view, the total sum invested yearly is compounded to ascertain the amount in the fund.

The basic model for sinking fund formula is as follows;

Sn = P{(1 + r) n-1} / r

Sinking fund calculation using the formula above.

Example 1

A project manager decides to borrow some money from a merchant bank to enable him to finance the replacement of an asset needed for a project.

The cost of replacement is $50,000.00 and the rate of return is 15 percent (15%). The manager makes an annual investment of $7000.00 in anticipation of the replacement of the asset.

Do you consider this provision adequate?

Using the sinking fund formula specified above, we have

$50,000 = P (1.15) 5 – 1 / .15

$50,000 = P (2.0114 – 1) / .15

$50,000 = P (1.0114) / .15

$50,000 = P (6.7427) / .15

P = $50,000 / 6.7427 = $7,415.43

From the above, the proposal was under-provisioned as follows;

The actual amount to be provided for = $7415.43

Amount provided in the proposal = $7000.00

Short fall = $415.43

Another Sinking Fund Example

Assuming we are interested in finding the sum that would accrue in a sinking fund factor if the manager invests $7500.00 for five years at the rate of 10 percent (10%).

Using the sinking fund formula

S = P {(1+r)n-1} / r

= 7500 (1.10) 5 – 1 /  . 10

= 7500 x 6.1051 = $45,788.25

Don’t Miss!!!

The creative ways to save money on a tight budget

Garnishee Order: everything you need to know

How long does it take to close a bank account

How long can a bank freeze your account for suspicious activity

This is where I wrap it up on sinking fund formula, categories and examples. I hope this article helps you to start saving money today.

1 thought on “Sinking fund formula & categories (Examples)”

  1. Hi Missy,

    Thanks for that wonderful guide. Great insight into purpose and insight of sinking fund. That’s a good share. Please can you mage some of your guides available in PDF so that we can read later.

    Reply

Leave a Comment