What Is the Difference Between Amortization & a Sinking Fund?

Both sinking funds and amortizations involve you making regular payments in installments to reach a certain figure and use it toward a specific purpose. However, they have significant differences in features, such as timing and interest. In a way, amortization is the opposite of a sinking fund with regard to the timing of the cash flows.

With an amortization, you usually obtain a loan to make a purchase at the beginning, and pay off both the interest and the principal over time. Interest is the amount you pay the lender for extending the funds to you, and principal is the amount you originally borrowed. With a sinking fund, you may purchase the item with cash. This happens when you set aside some money regularly to save up for a purchase. Alternatively, you may also get a loan whereby you pay the interest over time and pay the entire principal at the end.

With an amortization, you know the amount you originally borrowed, and the lender calculates the amount of each payment installment for you, but you may not know the total amount you actually pay over the amortization period until it ends. With a sinking fund, you know the amount you want to have at the end, and you calculate the amount of money you have to set aside each payment installment to obtain that figure.

With an amortization, you incur an obligation at the beginning by taking out a loan. As you make your payments, your outstanding amount decreases until you eventually finish paying off the loan. With a sinking fund loan, you also incur an obligation at the beginning, but your outstanding loan amount stays the same as you pay only the interest. You then pay the entire principal at the end and eliminate the loan. With a non-loan sinking fund, you save money now to pay for a future obligation.

If you take out a sinking fund loan, you pay the interest each period and also set aside an amount of money each period. If interest rates on the interest and the side fund are the same, you would pay the same amount in regular installments as if you were to take out an amortization loan. On the other hand, if you use a sinking fund account to save up for a future obligation, you would earn interest on your money, reducing your interest expenses.