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What is the Difference Between Emergency Fund and Sinking Fund?

Savings are truly an excellent approach to meeting a specific future goal or expenditure by keeping substantial money apart beforehand. Both sinking funds and emergency funds are two crucial types of savings. Sinking funds help you save money for planned expenses, such as a vacation or home renovation.

In contrast, an emergency fund provides security for unplanned expenses, such as sudden job loss or unforeseen medical expenditures. Keep reading to get a deeper insight into emergency funds vs sinking funds.

What is an Emergency Fund?

According to financial advisors, an emergency fund refers to the amount required to cover an unforeseen period's expenses. Creating an emergency fund is an integral part of financial planning which suggests the investors accumulate a fund as capital reserved to meet financial or personal crises.

Usually, these funds are held in liquid assets like a savings account, overnight or liquid mutual funds, money market instruments, etc. The principal aim of building emergency funds is to enhance wealth and strengthen financial safety and liquidity.

What is a Sinking Fund?

Sinking funds refer to a kind of fund specially generated for repaying debt. The holder of this account keeps a lump sum amount of money aside monthly, quarterly, or annually and uses them to fulfil their need afterwards. Several organisations often come across a hefty outlay while paying off debts and bonds issued earlier.

Under such circumstances, a sinking fund comes in handy in order to reduce the burden of this sizable cost. Sinking funds are set up so an organisation can easily contribute and pay off its debt fund over the years and avoid disbursing a large sum at maturity.

Difference Between Emergency Fund and Sinking Fund?

Unlike an emergency fund or savings account, a sinking fund is generated to meet a singular purpose. Mentioned below are the key differences between an emergency fund and a sinking fund:

Perspectives	Emergency Fund	Sinking Fund
Saving Goal	Emergency funds are saved to meet unforeseen expenses in the future.	In the case of sinking funds, a lump sum is saved for a scheduled future expense.
Time to Set It Up	It remains intact and fully funded until an unexpected expense arises.	It depends on the funds required to meet a particular future payment.
Who Avails Them	Emergency funds are mainly availed by individuals.	In the case of sinking funds, they are mainly availed by companies.
Liquidity	Emergency funds are more liquid than sinking funds.	Sinking funds are less liquid than emergency funds.
Target Amount	Emergency funds are usually around 3 to 5 times the monthly living expenses.	Depends mainly on the required amount of future expenditures.
Number of Funds	Number of funds is only one.	The number of funds can be more based on the organisation's savings goal.

How to Build an Emergency Fund?

Following is the easy step-by-step process to build an emergency fund:

Step 1: Analyse Your Monthly Expense

Firstly, you must determine your monthly expenses for daily necessities such as food, water, rent, electricity, and insurance.

Step 2: Decide the Amount to Be Saved

Preferably, when it comes to an emergency fund, you should save 3 to 5 times your monthly living expenses. Remember, the higher the amount, the more financial stability you can get during an emergency.

Step 3: Determine the Time

Once you have chosen the amount of your emergency fund, calculate the time required to save it in due course. The average time necessary to build up an emergency fund is 18 to 24 months, depending primarily on your saving pattern.

Step 4: Add It to Your Budget

After determining the time required to save the entire emergency fund, you must include your emergency fund within your budgetary plan so that it helps streamline the savings procedure.

Step 5: Choose a Savings Instrument

Once you have determined your emergency fund and the time required to save it, consider choosing a savings instrument wherein you can put your fund. Make sure you choose a convenient instrument, such as a money market fund, high-yield savings account, fixed deposits (FDs), sweep-in-accounts, liquid funds, etc.

Step 6: Start to Make the Savings

As soon as everything is arranged, you can start to save your emergency fund. If necessary, you may expedite the savings procedure by setting off anything.

What are the Categories of an Emergency Fund?

In terms of categories, emergency funds are classified into two types, as discussed below:

1. Short-Term Emergency Funds

Short-term emergency funds refer to those emergency funds required by an individual in the event of emergencies. Although this type of fund offers minimum interest benefits, it enables instant accessibility so that during any financial crisis, you can use them to meet your expenses.

2. Long-Term Emergency Funds

Long-term emergency funds are those saved specifically for large-scale emergencies comprising various natural disasters like earthquakes, floods, drought, storms, etc., or severe medical crises. The long-term emergency funds must be invested in those instruments offering a higher interest rate and taking several days to liquidate.

How to Build a Sinking Fund?

Sinking funds entice many investors since it makes them believe that an issuer will not default on their outlays. Mentioned below is the step-by-step process to build a sinking fund:

Step 1: Decide the Savings Goal

At first, you have to determine the purpose of saving and the total amount of money required to meet that expense. You must thoroughly research your organisation's financial background and estimate a rough figure for this.

Step 2: Choose the Timeframe

After computing a rough amount in mind, you have to think about the time required to save up that amount. Doing so lets you figure out the exact amount you can save every month.

Step 3: Think About the Budget

Once you determine the amount of money you can save monthly, ensure you include your sinking fund in the budgetary plan. With this, you will be able to start saving straight away.

Step 4: Select the Saving Instrument

While saving, you can choose high-yield savings accounts, short-term bonds, money market fund accounts, a Certificate of Deposits (CDs), or various other savings options. A money market fund is ideal since it provides higher returns, liquidity, and lower risk.

Step 5: Start Saving

Once everything is set, you can start saving. Convey your sinking fund target into the savings account each month and continue to save until you achieve the target.

What are the Categories of a Sinking Fund?

Sinking funds are classified into four types in terms of categories. They are as follows:

1. Specific Purpose Sinking Fund

As its name suggests, Specific Purpose Sinking Funds are those funds an organisation generates to fulfil a specific purpose, for example, buying machinery, furniture, etc.

2. Purchase Back Sinking Fund

The Purchase Back Emergency Funds are another type of sinking fund that an organisation creates when they require buying a bond back that can be repurchased at the sinking fund price or its market price.

3. Regular Payment Sinking Fund

A company creates Regular Payment Sinking Funds when making recurring payments such as payments to trustees, bondholders, or interest holders.

4. Callable Bond Sinking Fund

The Callable Bond Sinking Funds refer to those an organisation maintains for calling the bonds issued at a fixed call price. The callable funds also help a company pay off their debts early.

From the above discussions, you should have a comprehensive concept of emergency funds vs sinking funds. In a nutshell, since both are savings methods, they provide peace of mind to an individual or an organisation regarding financial uncertainties.

Once an ample fund has been established, people can relax with the feeling that they do not have to struggle in case a severe financial scarcity arises.

FAQs about Emergency Fund Vs Sinking Fund

Is the sinking fund portion of cash?

Sinking funds are cash set aside to be used afterwards to pay off a debt, bond, or preferred stock. It can also be utilised to fund an asset's purchase.

How can I compute a sinking fund?

To compute a sinking fund, you will require the periodic contribution alongside the annualised interest rate, number of years, and number of expenses every year. After this, you can use a sinking fund calculator to proceed with the estimation.

What are the advantages of an emergency fund?

Some of the noteworthy advantages of emergency funds are as follows:

Lessens stress levels
Avoids bad debt
Emboldens saving behaviour
Reduces retirement savings
Prevents lavish spending

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Disclaimer

This is an informative article provided on 'as is' basis for awareness purpose only and not intended as a professional advice. The content of the article is derived from various open sources across the Internet. Digit Life Insurance is not promoting or recommending any aspect in the article or its correctness. Please verify the information and your requirement before taking any decisions.
All the figures reflected in the article are for illustrative purposes. The premium for Coverage that one buys depends on various factors including customer requirements, eligibility, age, demography, insurance provider, product, coverage amount, term and other factors
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