What is Contingency Fund?

Remember the last time your young relative died in an accident and all of you had to fly immediately paying sky-high airfares. By the time you landed, you were running low on cash. You had to sell some of your stocks using the Encash facility to generate same-day liquidity. However, you may have lost out on the capital appreciation and your goals would have been disrupted. You can avoid such situations with a contingency fund.

Exactly, what is a contingency fund? In the above situation, you could have saved the embarrassment if you had a contingency fund. Let us look at the contingency fund meaning in detail.

Understand Contingency Fund

To understand the contingency funds meaning, one must appreciate the fact that we all live in an uncertain and unpredictable world. The best you can do is to prepare yourself with a contingency fund. You can avoid being thrown off guard by such contingencies. But how much should you have in a contingency fund?

To define a contingency fund is a liquidity buffer is set aside specifically to take care of such exigencies. It helps take care of such unforeseen emergencies and should ideally stay invested in very liquid assets like liquid funds, short-term funds, bank deposits, etc. The primary objective here is not returns but to enhance your financial stability and protect your financial plan in emergencies. There are no rules to do it but the thumb measure is that your contingency fund should ideally consist of 5-6 months of total income.

Now, creating such a contingency fund has some unique advantages. Firstly, it helps you tide over an emergency and you can do so without taking on any unforeseen debt. Secondly, a contingency fund also helps you to avoid disrupting your core plan by doing a fire sale of your star stocks. Lastly, it works like an insurance or a risk management tool for your financial plan. It may not add to your returns but saves the blushes on a rainy day.

What are the Advantages of a Contingency Fund?

It is said that the importance of a contingency fund can never be understood unless you land up in a mess. But you don’t need to wait till you get into a mess before planning your contingency fund. Here is why.

• The contingency fund saves you from falling into a debt trap at short notice. In the digital day and age, nobody carries cash in their wallets. But it is essential to have access to emergency cash. If you end up borrowing to meet such expenses, it does not make sense as you may get out of the emergency but land up in a debt trap. Therefore, the contingency fund helps you to overcome your reliance on too much debt.

• A contingency fund can help finance major exigencies. Typically, a contingency fund sets aside around 5-6 months of expenses to be used in a contingency. This offers you the capability to meet large cash emergencies with little disturbance to your lifestyle or your long-term goals. The absence of such a contingency fund could be dangerous if you get into emergency requirements like medical conditions, natural disasters property loss, etc. That is where a contingency fund comes in handy.

• The contingency fund is not only to meet unexpected liquidity needs but also to help you through tough periods when you have say lost your job or embarked on a business venture. The moral of the story is to use your contingency fund money only for such exigencies and try and replenish the fund immediately.

Advantages of Financial Planning

Here are some of the key advantages of financial planning.

Thanks to financial planning, you don’t compromise on your lifestyle by factoring in inflation and other factors and planning your allocation of assets accordingly.

1. One of the key benefits of financial planning is that it provides direction and purpose to financial decisions. Financial planning is about giving that much-needed reassurance.

2. Financial planning makes dreams actionable. Dreams are one thing but you need an action plan. Financial planning juxtaposes what you are with what you want to do and bridges the gap with planning.

3. Financial planning prepares you to meet all kinds of situations at all times. This compels you to look at practical answers and solutions to real problems.

4. A financial plan is like a strategy sheet. With the same finances, different people can create different levels of wealth with financial planning. It helps you meet your life goals through ups and downs by making the best allocation of resources.

5. Thanks to financial planning, you don’t compromise on your lifestyle by factoring in inflation and other factors and planning your allocation of assets accordingly.

6. Financial planning forces much-needed discipline in people. This is an oft-ignored but very important merit of financial planning.

7. You get the benefit of expert counsel and a guide to handhold you through the vagaries of the financial rollercoaster. You are more likely to meet goals with a financial mentor.

Frequently Asked Questions

Difference between contingency fund and mutual funds?

Mutual funds are investments that create wealth over time. Contingency fund is only meant of emergencies and is a provider of liquidity in tough times.

How much should be my contingency fund?

There is no hard and fast rule, but as a benchmark, your contingency fund can be about 5-6 months’ income. Replenish your contingency fund when you use it at any point of time.