sinking fund method

There are two ways to clear a debt over time. One is to chip away at the balance directly with each payment, which is amortization. The other keeps the original debt untouched until the end and meanwhile builds up a separate savings pot that will be exactly large enough to pay off the whole debt in one lump when it comes due. That savings pot is the sinking fund, and repaying a loan this way is the sinking fund method.

Under this method the borrower does two things each period. First, they pay the lender interest on the full original loan — the principal never goes down, so this interest payment is the same every period. Second, they deposit a fixed amount into a separate sinking fund earning its own rate of interest, sized so that the fund accumulates to the loan amount exactly at maturity. The deposit is the loan amount divided by the accumulation factor s-angle-n at the sinking fund's rate. The borrower's total outlay each period is the interest payment plus the sinking fund deposit.

The method matters because the sinking fund can earn a different (sometimes lower) interest rate than the loan charges, which changes the true cost of borrowing compared with plain amortization. If the sinking fund rate equals the loan rate, the two methods cost exactly the same; if it is lower, the sinking fund method is more expensive. Corporations historically used sinking funds to retire bond issues, and the concept also illuminates how to compare financing options honestly. A subtlety worth flagging: in the sinking fund method the debt sits at full value the whole time, so the borrower's net position is the loan minus the growing fund.