Ever heard of safety nets?
Seen them on construction sites? They keep the workers safe if they slip and fall off a higher floor – or when a heavy object falls from a height, to keep the pedestrians safe.
That’s what contingency funds do. Keep you safe when your finances plummet for an uncertain reason.
There’s hardly anyone blind to the importance of insurance. It makes emergencies and uncertainties easier to deal with.
But what about situations that leave your life unharmed, but drastically impact your earning capacity? Lay-offs, recession, pandemic, slow business – there’s so much you don’t have control over. How do you cope with your finances then?
Imagine having a backup ready, not having to worry about the following months, even in a grave crisis. Impossible? Nope. Doable? Very much!
This is what contingency funds are all about. These funds are to use for a contingency only – when an uncertain event confirms its occurrence.
A contingency fund saves you from a financial crisis.
It is a safety net, an airbag, people often don’t think about. An airbag that keeps your finances unaffected, even in uncontrollable situations.
This fund is an accumulation of a certain number of months’ (ideally 3, increasing it gradually) expenditure. Usually, people invest a fixed amount in a dedicated instrument monthly till the total expenditure of the said months is accumulated.
It protects you from the mind-numbing impact of unforeseen circumstances and the ensuing financial burden.
It enhances your financial stability because you don’t have to run helter-skelter for a floater. It protects your financial plan, keeping you on track.
So, what do you do when the amount is accumulated? Forget about it! Let it enjoy the magic of compounding as you keep adding your funds regularly.
Then, when life hits, you can redeem those, keeping your pocket free of a big burn.
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Why do you need a contingency fund?
Uncertainty. It is the only constant of life, right? You could simply go with the flow, fly in times of crisis, or prepare yourself with armor to fight it.
Now wealth cannot control circumstances, right? You cannot guarantee zero downfalls or failures just because you mint money. But when you utilize it well, you can mitigate the impact of future uncertainties.
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Here is why you need a contingency fund:
When an emergency strikes, people usually turn to debt. This increases your financial burden in an already unpleasant circumstance. If you are prepared beforehand for the same, you save yourself from the woes of repayment and burdening your shoulders long after the emergency is in the past.
When your earnings are compromised, be it due to medical reasons, or external factors, the contingency fund helps compensate for the loss. This helps you maintain your lifestyle while fetching you time to solve the crisis.
Irrespective of your income levels, certain expenses need to be met, month on month. Example – rent, EMIs, groceries, house help, etc. So that you do not have to cut down on these essentials, you need a fund that would cater to these expenses.
With the contingency fund ready, in the worst of circumstances, you may not be able to spend on luxuries or wants, but needs will be taken care of.
Once the essential expenses of say, 3 months are ready, you can keep adding funds to the corpus, eventually making way for your entertainment/luxuries as well.
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How to plan a contingency fund:
Most advisors suggest starting with calculating the expenses for 3 months and keeping that ready. Once the first three months are set, you can expand the corpus with additional months.
As you earn, part by part, park a portion of your income in a safe, liquid instrument. Keep it untouched till the purpose of this fund has not been met.
Liquid instruments are easier and quicker to redeem. Moreover, these instruments are not heavily risk-driven, so your funds do not erode. Plus, it also gets some, if not the entire, benefit of positive market fluctuations.
Once you have the corpus to keep you safe for about 12 months, you can include non-survival expenses as well.
Where to keep contingency funds?
Many hold the perception that it lies idle; there is no return on investment; it is best to invest in equity or debt. But if you do that, it entails risk. Equity and debt instruments limit your withdrawal amounts as well as the investment tenure. Moreover, they are heavily exposed to fluctuations.
So, what do you do?
Invest in liquid funds or ultra-short-term debt funds. They earn better interest rates than banks and keep you safe from extreme market fluctuations as well. A complete win-win!
The last word:
All said and done, the idea is to be ready. When you plan your life’s goals, personal, travel, financial goals, and career goals, do not forget to include contingency funds as well. Because once financial stability sets in, any crisis can be easily dealt with.