KNOWLEDGE CENTRE Financial Planning / What Is A Contingency Fund And Its Importance?

What Is A Contingency Fund And Its Importance?

Life being unpredictable can throw surprises and catch you off-guard at any time. Not anticipating beforehand for such situations not only puts you in a difficult situation at those moments, but also derail your future plans as you are forced to either dip into your savings or take on additional debt. Therefore, planning ahead for such situation is extremely necessary and makes it an important part of any financial goal planning.

A contingency fund is hence a fund that is designed to be used for meeting any unforeseen emergencies and may be either in cash or liquid assets. The primary objective is to enhance your financial stability and to protect your financial plan in case of emergencies. The contingency also helps you from taking credits from high interest option such as credit cards.

What Are The Advantages Of A Contingency Fund?

A contingency fund may be used to meet the below mentioned three emergencies:

1. Contingency fund protects you from taking on additional debt
2. Contingency funds help you to finance major emergencies
3. Contingency funds help you to meet large expenses in unforeseen circumstances

Let’s expand on these points to understand them better:

  1. Contingency fund protects you from taking on additional debt

    An important use of such funds is to protect you from relying on credit to meet unexpected cash requirements. In case an emergency, you don’t always have large amounts of money at hand, and are hence forced to avail of a loan or use credit card to meet such needs, it may have to service the interest and principal repayment for several years. A higher amount of debt may not have short term effects in your daily life, but even affect any savings or investment plans you might have made for the future. Therefore, a contingency fund helps you to overcome your reliance on too much debt.

  2. Contingency funds help you to finance major emergencies

    Such a fund helps you to meet emergency fund requirements. Simultaneously, you may continue to your day-to-day expenses and even your long-term financial plans you’re your children’s education, easy retirement, or taking that dream vacation. A contingency fund offers you the capability to meet large cash emergency needs with very little disturbance to your abilities to continue paying your regular expenses. In the absence of such a fund, emergency requirements, such as medical conditions, natural disasters, or damage to your property, etc. may create havoc to your financial situation. You may find it difficult to carry on your regular life, which may have severe outcomes.

  3. Contingency funds help you to meet large expenses in unforeseen circumstances

    The importance of a contingency fund is not only to meet unexpected liquidity requirements. The fund may also be used to meet large expenses in-case you decide to leave your job, or stop making money from your primary source of income. However, it is important for you to use the contingency fund only to meet such money requirements in crisis situations that require immediate money, and not to spend the money for other uses.

How To Start A Contingency Fund?

You must build contingency funds based on your specific requirements. Most financial advisors recommend that you keep at least 6 months to 2 years of your annual income parked in your contingency funds. These funds offer financial protection to counter unforeseen emergencies. The money in your fund doesn’t need to be idle. You can invest the money in an instrument that offer good returns while still exposing your portfolio to minimal risk.

What Are The Misconceptions Surrounding Contingency Funds?

Some individuals consider that the amount lying in the contingency fund is idle and not earning any returns. They may invest in assets, such as equity, debt, or gold. Direct equities are risky, debt investments are long-term and often do not allow premature withdrawal (except without the levy of penalties), and gold prices are subject to fluctuations. A more reliable and lucrative option is to buy liquid or ultra-short term debt funds. Asset management companies (AMCs) offer these debt schemes that give you a better interest rate than savings accounts or fixed deposits, but still mitigate the risks to your portfolio and keep them to a minimum.

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