What is a sinking fund?
A sinking fund is a dedicated savings account used to accumulate money gradually for a specific future expense or obligation. It operates on the principle of consistent, periodic contributions to reach a predetermined target amount by a set deadline. This targeted saving strategy helps individuals and entities plan and prepare for predictable, large expenses, preventing financial strain when the time comes.
Sinking Fund Example:
Imagine Sarah wants to go on a vacation to Japan in two years. The estimated cost is INR 5,000. Setting up a sinking fund, she decides to contribute INR 200 per month for 24 months. By diligently placing INR 200 into her fund each month, she will have accumulated the INR 5,000 needed for her trip when the time comes, avoiding the burden of last-minute scrambling for funds.
Sinking Fund Method:
The sinking fund method involves calculating the required contributions and consistently depositing them into the designated fund.
Here's how the method works:
1. Define your goal: Identify the specific expense you are saving for and its estimated cost.
2. Determine the timeframe: Calculate the time horizon or the period until you need the money.
3. Calculate the periodic contribution: Divide the target amount by the number of periods to determine the required regular contribution. For example, if your goal is INR 5,000 in two years (24 months), your monthly contribution would be INR 5,000 / 24 = INR 208.33.
Sinking Fund Formula:
To further refine your calculations, you can use the sinking fund formula:
P = (F - A)/n
P: Periodic contribution amount
F: Target amount you need to accumulate
A: Any initial amount already saved (optional)
n: Number of periods for saving
Let's revisit Sarah's example using the formula:
P = (INR 5,000 - 0)/24 = INR 208.33
This confirms that Sarah needs to contribute INR 208.33 per month to reach her vacation goal.
Benefits of Using a Sinking Fund:
By implementing the sinking fund strategy, individuals and entities can effectively plan for future financial obligations, achieving their goals without compromising their present financial well-being.