What is a Sinking Fund?
Companies use sinking funds to save up for debt repayments. But can the concept apply to our personal finances as well?
July 27, 2022
The term “sinking fund” is commonly used in corporate finance. But the concept can also apply to our personal finances.
In this guide, we’ll break down:
What a sinking fund is
How sinking funds work
Why everyday people should consider setting one up
What is a sinking fund?
In corporate finance, a sinking fund is a fund with money set aside to pay off a bond or other type of debt.
When companies take out loans or sell bonds, they know they will have to pay off the debt at some point. With bonds, the bulk of the payment occurs at once when the bond matures.
Sinking funds help prepare for this large one-time expense. A company might set up the fund and contribute to it every year up until the bond matures.
In other words, sinking funds are a way for companies to budget for upcoming large debt payments.
Sinking funds are typically kept in low-risk, liquid savings. They are not typically invested, although companies may keep the funds in a high-yield savings product or money market account.
How can the concept of a sinking fund apply to personal finance?
“Sinking fund” describes an activity in the finances of large companies. However, the same basic concept can apply to personal finance. Here are some situations in which a sinking fund might be appropriate:
Upcoming major purchases
A sinking fund can be considered a way to save for a large upcoming expense. In this context, you could choose to use a sinking fund to save for any number of significant expenses, including:
Major home renovations
Major planned medical expenses
Major vehicle repairs or replacements
An upcoming vacation
Paying large tax bills
Buying new furniture
Essentially, you can use a sinking fund to set aside money for a future major purchase or expense. The point is to use it for a specific purpose rather than for general savings.
Loans with a balloon payment
Some loans are known as “balloon loans.” They have regular monthly payments, then a large one-time payment due at the end of the loan. Balloon loans are sometimes used for mortgages and business loans, although they are relatively uncommon.
With a balloon loan, a large — or very large — payment will be due at the end of the loan term. Individuals can set up a sinking fund to save for the balloon payment to prepare for this.
How to set up a sinking fund
To set up a sinking fund, individuals should select the purpose, set a goal for the amount saved and then open a dedicated account for the fund. From there, it’s all about saving money towards the goal regularly.
Sinking funds are typically kept in liquid savings, which should be easily accessible. Consider a high-yield savings account, which pays more interest than a typical savings account. Another option would be savings bonds, particularly Series I savings bonds (I-Bonds).
It’s usually wise not to invest the money you plan to use for a sinking fund. Investments can lose value over short periods, so it’s best to keep your savings in a low-risk, liquid format like a savings account.
Sinking fund vs. emergency fund
An emergency fund is an account set aside for emergency expenses and unexpected loss of income. It’s a general-purpose fund, meaning that it might be used for a surprise medical bill or an unexpected car repair, or it might be used for living expenses in the event of a job loss.
Sinking funds, on the other hand, are set aside for a very specific purpose. The funds are earmarked for a particular expense, which is often known to be coming after a certain time.
Ideally, everyone should have an emergency fund — and many could also benefit from a sinking fund. But if you have to choose, an emergency fund should be your priority.
Like a sinking fund, emergency funds should be kept in liquid savings, like a savings account.
Saving money vs. paying off debt
If you know that you will have major expenses in the future, it may be wise to start a sinking fund to prepare. However, if you have debt, it may be optimal to pay off that debt first.
This is particularly true if you have high-interest debt, from things like credit cards or personal loans. These forms of debt can be very costly due to high-interest rates.
To illustrate, let’s look at an example.
Samantha has $5,000 in credit card debt at 20% interest
She knows that she will have a roughly $5,000 home renovation project in the next few years
She has about $200 per month in extra money that she can use to pay off her debt or save for the home renovation
If Samantha makes the minimum payments on her credit card debt, her debt will continue growing. The debt is costing her over $80 per month in interest alone.
In this case, it makes far more sense for Samantha to put that entire $200 per month towards her credit card debt. In doing so, she could pay off the debt in less than 3 years — and then start saving for the home renovations.
If you’re like Samantha and have credit card debt of your own, Tally† might be able to help. Tally helps qualifying applicants consolidate their credit card balances to pay less interest. Learn more about how Tally works here.
Companies use sinking funds to budget for major debt repayments in the future. Individuals can use them to prepare for major upcoming expenses.
Before utilizing a sinking fund, it’s wise to examine your other financial priorities. Do you have debt that you should tackle? Are your retirement plans on track? Zoom out to get a picture of your financial situation.
For more helpful resources on personal finance, check out the rest of the Tally blog.
†To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. Based on your credit history, the APR (which is the same as your interest rate) will be between 7.90% - 29.99% per year. The APR will vary with the market based on the Prime Rate. Annual fees range from $0 - $300.