Contingency Fund – Are you ignoring an essential?

Investment

oi-Sneha

By Perfios Money Manager

Updated: Tuesday, May 7, 2013, 10:03 [IST]

Let us first understand the meaning of the word "Contingency". Contingency may be defined as an event that may occur but that is not likely or intended. It is a possibility that one must be prepared for, like a future emergency.

Hence it is an eventuality, perhaps not a pleasant one, which we need to be prepared for at all times. For example a loss of job or a medical emergency may happen suddenly without giving you much time to prepare for it. Here is where a contingency fund can come to your rescue and at least lessen the financial impact of the event.

Having a contingency fund in place is an absolute essential for any household. The purpose of a contingency fund is to help you tide over unexpected situations which may require a financial outflow and which are not covered by any other means such as insurance. It provides ready resources to tide over the immediate financial need without having to borrow or disrupt long term investment plans.

Having understood the purpose of a contingency fund, let us look at how much should it be and how it can be set up. A contingency fund should be equal to 4-6 months expenses of the household. In case of working couples, 3-4 months of expenses set aside towards contingency should suffice. And how should this money be held? Partially in your savings account and largely in highly liquid and safe investment products.

Basically, in case of any urgency, money should be available within 24-48 hours. So while 1-2 months of expenses can be maintained in the savings account, the balance 3-5 months expenses can be set aside either in a liquid mutual fund or flexi deposit account where it is equally safe and liquid and yet earns a better return.

Let's understand using a scenario - Mahesh lives with his wife Gita and 2 children. He works for an MNC and earns a salary of Rs 1.5 lacs per month of which Rs 60,000 goes towards EMI on his house. Another Rs 40,000 per month goes towards essential household and utility expenses and school fees of children. An amount of Rs 20,000 per month goes towards discretionary expenses such as dining out and shopping. So he saves Rs 30,000 a month which he invests in equity towards long term goals.

Mahesh never has more than Rs 30,000-40,000 in his savings account and all his investments are earmarked towards future goals. He has been planning to set aside a contingency fund for a long time but never finds any funds available. He has never felt the need either.