Aren’t we all by now privy to a world that can suddenly come to a standstill—as happened during the COVID pandemic? Zoom in to a micro level, and you will have encountered plenty of emergencies with severe financial ramifications. It could be a medical emergency, a salary cut, or the promotion bonus that you had been eyeing for quite some time not coming through.
The crux is life can be unpredictable and can catch us off guard. While it is impossible to predict such events, we surely can plan for them. That’s where a contingency fund comes into the picture.
What is Contingency Fund?
A contingency fund, or an emergency fund, is a savings pool created to deal with unanticipated adverse financial events. Such a fund is usually invested in cash and highly-liquid assets.
In other words, the contingency fund meaning refers to the money that has been kept aside to deal with financial emergencies, thereby enhancing financial security. Thus, it acts as a strong cushion in times of financial distress.
Examples of Contingency Funds
One contingency fund example that we all are familiar with is the Contingency Fund of India, meant for meeting expenses in case of emergencies, such as wars, natural disasters, riots, etc. Additionally, many businesses also create emergency funds to meet unforeseen expenses. For instance, a company may be waiting for a legal order, which could involve financial penalties.
In a similar vein, individuals must create their contingency funds to not be derailed from their financial track when life gives lemons instead of lemonade. But, how much should you park in a contingency fund?
What is the Optimum Size of a Contingency Fund?
A general rule of thumb is to maintain 3 to 6 months’ worth of living expenses in your contingency fund. But this amount will need to be further streamlined as per your family size, quantum and stability of family income, the standard of living, and pre-existing medical conditions.
Kindly note that an emergency fund does not account for entertainment expenses. For example, if your basic monthly expenses amount to Rs. 25,000, then a sum between Rs. 75,000 to Rs. 1,50,000 should be kept in your emergency fund.
How to Maintain a Contingency Fund?
The point of keeping a contingency fund is to fund your emergencies. Hence, it becomes imperative that a contingency fund should be liquid and accessible. This implies that if you are planning to invest your emergency funds, ensure that you can quickly liquidate your investments with minimum tax implications. Some of the instruments that you can explore are listed below.
FD Account
One of the most popular ways of saving up emergency funds is to open a fixed deposit (FD) account with a reputable bank/ NBFC/ neobanks, preferably with the ones offering higher yields. You must also check out their terms on early withdrawals and penalties. Alternatively, you can allocate some amount to a savings account while keeping the rest in a Flexi-FD account.
Short-duration Debt Funds
Unless you are highly risk-averse, you can park your funds in a short-duration debt fund or a liquid fund. Choose wisely, as some of the actively-managed funds may run up high expense ratios, thus reducing your overall return.
Savings Account
If you value security and don’t mind the low rates of interest, then you can consider opening a savings account with a sweep-in facility to invest your potential contingency expense. A sweep-in facility allows you to channel any surplus amount (over a set limit) into an FD.
Cash
It is, after all, a fund for a rainy day; individuals should keep an optimum amount of ready cash on them at all times.
What are the Benefits of Keeping a Contingency Fund?
An ideal way to deal with financial emergencies is to create an emergency fund. Below, we mention some of the benefits of having a contingency fund in place.
Shields Against Additional Debt
Consider a scenario, where you need to cough up a considerable amount for an unexpected medical emergency. Without a contingency fund, you will be forced to take on debt—at high-interest rates, in some cases—to meet these unanticipated expenses. This could, then, seriously throw your financial plan in jeopardy while saddling you with humongous interest and principal payments to be paid off over several years.
Reduces Stress
Sudden cash outflows due to an emergency can result in a huge mental and emotional toll, in addition to throwing your budget haywire. Topping it off with a high-interest loan to cover contingency expenses can further add salt to the injury. With a contingency fund, you can rest assured of paying up any unforeseen expenses.
Better Decision Making
The best practice is to maintain an emergency account distinct from your normal banking account. Once you have clearly earmarked your funds for meeting living expenses, savings, and contingencies, it becomes easier to decide whether to splurge on those occasional moments.
Meet Financial Goals
A contingency fund enables you to pay for unplanned costs without compromising your ability to meet your living expenses. Thus, you can continue with your long-term investment plans, staying on track to meeting your wealth creation goals. You can also plan on how to rebuild your emergency fund, as and when it is used up to meet unsought expenses.
Bottom Line
A contingency fund can help you to easily navigate tough times without hampering your financial goals, thereby guarding you against any undue mental stress. Hence, your aim should be to create an emergency fund as soon as you start receiving income. You should also revisit your calculations for living expenses from time to time so that they are in sync with your lifestyle. You can further build up your emergency account as per your updated requirements.
