Sinking Funds for Future Purchases

Sinking Funds for Future Purchases

6 second take: Whether you’re working on your business or your own finances, a sinking fund might be the right idea for you.

Sinking funds have been used by businesses and other entities for years. They use them to accumulate funds for a specific future need, typically to pay off debt they took on by issuing bonds. A sinking fund is used to accumulate the funds to pay off the bonds at maturity.

The basic idea is easily translatable to personal finance. People often know they will need, or at least want, a set amount of funds for a specific purchase at a set future time. A sinking fund is a great tool for that exact purpose.

Sinking Fund Basics

Businesses garner several advantages by using sinking funds. They reduce the uncertainty of where the necessary funds will come from when their time of need arises. They reduce the risk of default on the bond obligations, when using them to retire bonds at maturity. Both the firm and the investors have confidence that the funds will be there when needed.

The “sinking” in the term “sinking fund” is the reduction in net obligation.

If a business needs a few tens of millions to retire a bond issue four years from now, building a sinking fund across those four years reduces the future net obligation; the savings ultimately cancels the future obligation.

If the fund is built to fully pay off the business’ debt, then the net obligation at the bond’s maturity is zero; the accumulated savings is equal to the debt to be paid.

Sinking Funds for Consumers

The concept translates nicely to personal finance. An individual, or a household, can accumulate funds for a future purchase so at the time of purchase the net effective cost is zero — the funds are in place for the entire purchase.

It’s a simple twist on the business application: The business application sees the incurrence of debt, generally, in advance of accumulating the sinking fund; the personal application accumulates the fund to prevent the occurrence of debt.

Sinking funds are different from general savings or emergency funds because of their specific purpose. General savings or emergency funds are fungible accounts, ready to be used for whatever need presents itself. A sinking fund, conversely, is built for a specific known purpose, such as a car replacement, or a major vacation.

Sinking Funds vs. Investment Accounts

A sinking fund is a savings fund, not an investment account. The differentiation is one of time and often of scope. If you are building for a long-term goal, such as retirement or the education of your children, investment performance is generally a significant factor in that calculation. You can use the time value of money to your advantage.

When goals are nearer term, five years or less, volatile long-term investments are usually not advisable.

This is the realm of sinking funds, shorter and mid-range needs where you would save for the need, not invest in the markets for the need.

For investment goals, the time value of money is a significant factor. For savings goals, safety of principal is the major factor. Sinking funds are generally used for nearer-term goals where safety of principal concerns are preeminent.

Sinking Funds vs. Accrual Accounts

This may seem mostly semantic. An accrual account is a special form of a sinking fund. Accrual accounts are used when a need recurs on a regular basis, such as funding annual holiday expenses or accumulating for taxes or insurance. These needs are not one-and-done; they repeat and repeat again.

From a practical standpoint, it may be easier to work with separate accounts for accruals and sinking funds. Some people combine their accrual accounts into one, making regular payroll deduction deposits to cover their entire set of accruals. Others may find it helpful to separate the accounts, each with its own purpose.

The semantics aren’t important. Call them what you wish. It is more important to build the funds to have them there when you need them than to worry about their name. Accrual accounts are sinking funds that repeat, and sinking funds are a way to accrue for future needs. Clear?

Practical Considerations

Sinking funds help consumers avoid debt. Debt has a cost; by avoiding debt you avoid that cost. Sometimes the cost of debt is high. Especially for unsecured debt and more so for the credit challenged.

Predictable future expenses that can’t be easily absorbed into the monthly budget are ideal candidates for a sinking fund. Non-predictable future expenses are ideal for an emergency fund.

Car replacement, home remodeling, and major vacations are great candidates for a sinking fund. Too often people pay unnecessary interest on these expenses because they didn’t plan sufficiently in advance. That doesn’t have to happen to you.

Repeating expenses are ideal for the special application of a sinking fund: the accrual account.

It is exactly the same as any other sinking fund, except that you don’t stop funding it when you use it; you keep the funding in place for the next time the expense comes due.

Taxes (both income and property), holiday funds, annual vacations, and annual or semi-annual insurance premiums are all great candidates for an accrual account.

Sinking funds work best when automated. This holds true for investment accounts and other dedicated needs. The best strategy is one where you can set it and forget it, automating payments into a savings account or other account for your future needs.

Investors should be cognizant of fees when building these funds. Some accounts may have charges if minimum balances are not maintained; others may reward larger balances with higher interest earnings. As always, a little attention to the details can help maximize the results in your unique situation.  

The Bottom Line

A sinking fund is a fancy name for a single-use accrual account. And accrual is very useful. You can accrue for all kinds of things: things that you need once, things that you need repeatedly. They can be small things or big things. The technique works best in some specific instances.

Sinking funds work best for known future expenses that don’t fit nicely into your monthly budget. That’s why we tend to use them for cars and not cigars. If it would take more than one month’s discretionary income to purchase, it is better to save for it in advance.

It’s not always possible to jump right onto being on track. Sometimes you need to take smaller steps first. If you calculate that you would need to save $400 per month to replace your car in five years, but can afford to dedicate only $150 per month into a sinking fund for car replacement, by all means do it.

It is far better to partially prepay a goal than it is to do nothing at all. You may find that you can increase the amount you earmark to the fund over time, getting closer than you would have expected.

Businesses use sinking funds to retire debt they have taken on; you can use a sinking fund so you don’t even have to take on the debt. You can avoid the high cost of interest on purchases you are going to make anyway, such as a car. You also avoid the stress of determining how to pay for it at the time, making for a double win. There’s a lot to like in this simple concept, sinking the debt before it gets to your door.

LendingPoint is an Atlanta-based lender and servicer, redefining who can access money at fair rates.

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