Key Difference – Sinking Fund vs Amortization
Investing is an activity that contains a number of options that can often be tailor made to various investor requirements. Funds can be set aside for future use or can be borrowed in order to be used in an investment. The key difference between sinking fund and amortization is that while sinking fund is an investment that sets aside funds to meet a future investment need, amortization is periodic installments of a debt instrument such as a loan or a mortgage. Amortization is also the term used for the accounting treatment of recording depletion of intangible assets.
CONTENTS
1. Overview and Key Difference
2. What is a Sinking Fund
3. What is Amortization
4. Side by Side Comparison – Sinking Fund vs Amortization
5. Summary
What is a Sinking Fund?
Sinking Fund is a fund maintained by setting aside revenue over a period of time to meet a future capital expense. Periodic deposits will be made to an account which will earn compound interest. This is an interest calculation where the interest paid will be continued to add up to the principal sum (original sum invested) as it is paid. It is basically the interest on interest.
E.g. Assuming that a $1,200 deposit is made on the 1st of January at a rate of 10%, the deposit receives an interest of $120 month, continuing for 6 months. However, for the deposit made on 1st of February at the same rate, interest will be calculated not on $1,200, but on $1,320 (including the interest earned in January). The interest for February will be calculated for 5 months assuming that the sinking fund is for 6 months. It is important for an investor to know what is the total sum that the fund will have at its maturity; this can be derived using the below formula.
FV= PV (1+r) n
Where,
FV= Future Value of the fund (at its maturity)
PV= Present Value (the amount that should be invested today)
r = Rate of return
n = Number of time periods
Continuing from the above example,
E.g. FV= $1,200 (1+0.1)6
= $2,126 (rounded to the nearest whole number)
This means that if a sinking fund deposit of $1,200 is made on 1st of January, it will grow up to $2,126 by the end of 6 months.
What is Amortization?
Amortization refers to the periodic payment of a debt instrument such as a loan or mortgage. The amortized payments include a portion of capital payment (to compensate for the repayment of original sum borrowed) and a portion of interest. There are a number of online sites that conveniently help to calculate loan repayments by submitting the loan amount, interest rate and the number of years.
E.g. ABC Company took out a loan for $10,000 in January 2017 with an interest rate of 5% for a period of one year.
The monthly payment contains both the principal and interest. For the month of January, Interest will be $42.8 ($856*0.05) thus; the principal amount will be $813.2. Monthly payments for the subsequent months can be computed as per below. (Amounts are rounded to the whole number)
Amortization is also a term used to account for the depletion of the value of capital assets over time where this is a non-cash payment similar to depreciation, however, it is used only for intangible assets. Patents, copyrights, trademarks and business methodologies are intangibles amortized.
E.g. N Company own copyrights on the use of a certain technology which is estimated to last for a period of 10 years. The company incurred a total cost of $12.5m to develop the technology. $1,250,000 ($12.5m/10) will be amortized each year as an expense to the income statement.
What is the difference Between Sinking Fund and Amortization?
Sinking Fund vs Amortization |
|
| Sinking fund is an investment that sets aside funds to meet a future investment need. | Amortization is the periodic installments of a debt instrument such as a loan or a method of accounting for reduction in value of intangible assets. |
| Interest | |
| Interest will be received in a Sinking Fund. | Interest will be paid in Amortization. |
| Time Period | |
| Ending balance of a sinking fund is a significant sum of funds accumulated over time. | Ending balance is zero at the end of the loan amortized period. |
Summary – Sinking Fund vs Amortization
The difference between sinking fund and amortization can be described by the purpose of establishing either option and the behavior of interest payments/receipts. If the funds are accumulated over time before an asset is purchased, this is a sinking fund. Amortization occurs when debt is obtained at present to be settled in the future. Sinking funds assist in forecasting an amount of funds that will be received at a future date; thus it is an effective way of allocating funds. Since amortization for intangible assets is a non-cash payment, it is tax deductible.
References
1. “Ask Rescue Capital: The difference between annuity and amortization?” Rescue Capital Blog. N.p., 08 Sept. 2011. Web. 14 Mar. 2017.
2. “Amortization Calculator.” Loan Amortization Calculator | Credit Karma. N.p., n.d. Web. 14 Mar. 2017.
3. “Sinking Fund.” Sinking Fund | Definition | Formula | Example. N.p., n.d. Web. 14 Mar. 2017.
4. “Intangible Assets Accounting | Amortization.” AccountingTools. N.p., n.d. Web. 14 Mar. 2017.
Image Courtesy:
1. “Savings” via 401kcalculato (Public Domain)