Contingency Fund : Meaning and Importance

7 Mins

What is Contingency Fund?

A contingency fund is a fund created to protect yourself and your family in case of contingencies or emergencies. It could be a medical emergency, unavoidable home repairs, a sudden loss of employment, a salary cut, or something that affects the community as a whole, like a pandemic, war, social unrest, etc.

It can be either in cash or liquid assets and is a fund that is created to be used for handling any unanticipated situations. In other words, it is the money kept aside to use in the event of financial distress.

Its main goal is to enhance your financial security and safeguard your financial plan in the event of contingencies. Thus, it provides a strong cushion for your finances in case of a crisis.

Importance of a Contingency Fund

Let’s understand why it is important to have a contingency fund.

If you don’t have a contingency fund, you may have to borrow money or use a credit card to meet your needs. Additionally, you may have to pay back the principal and interest on the loan for several years.

Although having more debt may not have an immediate impact on your day-to-day activities, it may have a long-term impact on your future savings or investment goals you may have set.

The fund helps you meet your emergency requirements. You may simultaneously pay for your short-term necessities and long-term objectives like your children’s education, a secure retirement, or taking that long-awaited vacation.

The fund enables you to pay for major financial emergencies without significantly hampering your ability to continue paying your regular bills. A contingency fund could prevent you from becoming overly dependent on debt.

Without a contingency fund, unforeseen costs like medical bills, natural disasters, or property damage can hugely impact your finances and disturb your long-term investing.

Your investing could stop if there are too many unforeseen costs. It could be challenging for you to carry out your regular daily activities and long-term investment strategy, which could have huge effects on both your everyday life and your financial portfolio.

How to Start a Contingency Fund?

Now that we know the importance, let’s see how we can start a contingency fund.

First, track your expenses for a few months and see how much money you are spending on necessities. This will give you a rough idea of the amount that you may have to park in an emergency fund.

Set a goal: Once you’ve decided the amount that’s right for you, split out your goal into more manageable monthly payments. This helps you develop the habit of saving and reduces the difficulty of the work.
Maintain a separate account: To avoid being tempted to spend that money, it should be maintained using the out-of-sight, out-of-mind philosophy. Ideally, keep some money in savings and some in liquid funds.
Pay your future self first: As you plan for other financial goals, such as saving for a home or retirement, begin putting money aside each month as soon as you get your paycheck or money from your business. Automate the transfer if you can to ensure that your savings are addressed first.
Cut your expenses: Cutting back on non-essential expenses will help you reach your savings goals faster and may allow you to increase your monthly budget allocation. Prioritize your spending instead of completely cutting out all expenses. Reduce weekly outings to a maximum of one or two per month, watch movies at home, avoid excessive online shopping, etc.
Liquid funds: Invest the contingency fund requirements in a liquid mutual fund. Liquid funds are easily convertible into cash (in a day or two) and also provide better returns than bank deposits, which helps you match the inflation rate, if not beat it.

Common Myths about a Contingency Fund

Let’s look at some common myths that you’ll come across as you work to create an emergency fund.

My income is less

It may seem challenging to build an emergency fund when you are living paycheck to paycheck because you have nothing to put into it. But for the majority of us, there is something we can sacrifice from our budgets to establish a fund.

Suppose you are spending too much on shopping. Cut out a bit of spending on shopping and instead put that money into an emergency fund. If you continue to do this in a disciplined way for a few months, you will have enough money in your fund to be used in case of an emergency. Try it out!

The fact is that you probably need an emergency fund more if you make less money because you have less extra cash to use for unforeseen expenses. Start small, but do something!

I cannot save enough

Even if you aren’t living paycheck to paycheck, it may seem as though your emergency money will never be enough. There is some debate over how much cash should be kept in an emergency fund, but most sources agree that it should be enough to cover three to six months’ expenses.

For example, if your monthly expense for necessities is Rs. 40,000, you should have at least Rs. 2,40,000 in an emergency fund. That is, 6 months x 40,000 = Rs. 2,40,000. That might be a huge amount.

But here’s the thing: even if you can’t save as much as you’d want, it’s better to have something saved than nothing. You shouldn’t wait to start saving money just because you are unable to do it right now. And even if you never reach your ideal emergency fund amount, your savings will still be there to support you in times of need.

I have too much debt

It’s easy to think that you should pay off all of your debt before you even consider saving money. But when you don’t have an emergency fund, you frequently end up in deeper debt because you have to utilize credit cards or take out loans to cover unforeseen expenses. Over a lifetime, the compound effects of this might have severe financial consequences.

Typically, it is possible to save money and pay off debt simultaneously. Even if you only save a small amount each time you get paid, over time, this will add up. Simply knowing that you can save some money can give you a psychological edge.

I am too old or too young

You are never, ever too old or too young to start saving money. It doesn’t matter how old you are to start saving for emergencies; it doesn’t matter whether you’ve done it before or not and are starting afresh now.

The goal of an emergency fund is to have extra money on hand in case something unfavorable happens. You may lose your job, someone gets sick, or your vehicle requires repair. If you have not set aside money for all of these unforeseen expenses, you could find yourself in debt. And since they might occur at any time in your life, you should always be ready.

So, regardless of your age, start building your fund. Even if you believe that you will never be able to save the amount you desire or need to, every rupee you set aside will be beneficial if something unfortunate occurs.

Frequently Asked Questions

Where should I invest to create a contingency fund?

You can break down the salary into three parts. Keep aside 3-6 months of your salary/income for contingency. Ideally, hold the investments in liquid assets. These are easily and quickly convertible into cash as liquid funds offer better returns than a savings account.

How much should I hold in a contingency fund?

You should park at least 3 to 6 months’ income in your contingency fund. At least 3 months’ salary should be kept aside if you have a stable income. And if you don’t have a stable income (freelancer) or you have a dependent family to take care of, then at least 6 months’ income should be kept aside. Your contingency fund should have enough so that your lifestyle is not disturbed even when you face an emergency.

Is an emergency fund different from a contingency fund?

No, both an emergency fund and a contingency fund mean the same thing. Ideally, you should hold some money in liquid assets to meet unforeseen future expenses.