FundsIndia explains: Contingency fund and its importance

Your EMI is well within your capacity, you have no difficulty in meeting recurring expenses, and you even have a monthly surplus that you’re investing. Isn’t that a great position to be in? Well, yes. But there is one thing that you have missed out on. And that’s a contingency fund. Let’s see why it is important to have a contingency fund and how to go about maintaining one.

What is a contingency fund?

Contingency fund is the money you set aside for any unforeseen event that will disturb your financial stability. This could be a temporary stall in your regular income, say, due to a loss of job or change in job where you will have to go a few months without your salary. Or any unexpected large expense (like a medical emergency which your insurance won’t cover) that might affect your finances for months together.

Why do you need a contingency fund?

An emergency-like situation that requires a large spending on your part will immediately hit your finances. For example, natural calamities like a storm or flooding due to rains can damage your household goods which would need replacement. Circumstances such as loss of a job, or a few months without pay between jobs can have a similar effect.

So what happens? It might leave you unable to meet any loan obligations or even your monthly expenses. Or, you may find yourself unable to even meet that large expense requirement, requiring you to take a loan in order to pay for it. This in turn increases your monthly expenses for some time. And apart from potentially hurting your ability to meet your payments, it can also eat into your savings for future financial needs.

You could make arguments against the need for creating emergency funds. Let’s look at some:

1. I have a secure job (and I always will) – Even though salaried individuals enjoy a sense of security, some amount of uncertainty always persists. For those who have fluctuating monthly incomes, such as freelancers or self-employed, the lack of fixed certainty in cash flows makes it more important to have a contingency fund. There could also be times when your regular income is not sufficient to meet the emergency needs.

2. I have assets that I can bank on – Liquidity of the asset will be the main concern during a contingency. You might think that your house that’s worth a hefty amount of money or other investments will have you covered but unless they can be converted into cash immediately and without causing you a loss, they wouldn’t serve the purpose. So while you could withdraw your fixed deposit, you may pay a penalty. Taking out your provident fund money is a time-consuming process and comes with conditions. Selling your house is hardly an optimal choice. Remember that dipping into your other investments would also take you off your wealth building track and disturb the plan with which you would have made those investments.

How much should you have?

Ideally, your contingency fund should cover at least six months of your expenses. Components of expenses that you should include are EMI payments, insurance premium, utility bills and other recurring household and living expenses.

For some, this might seem like a huge amount to be built at once. But it isn’t necessary to build it at one go – you can do so gradually over several months. For instance, you could put however much you can today and top it up as and when you have a surplus. You don’t also need to prioritise building your contingency fund over building your wealth. You can do both together. Simply take out small portions of your regular monthly investments until you have your corpus done. If you haven’t started regular investments yet, set up a contingency fund first.

Once built, review it every two years or so to ensure it still matches your changing expenses and inflation. If you withdraw from it to meet any expense, top it up as soon as you can.

Where do you park your contingency fund?

Keeping in mind the purpose of a contingency fund, the aspects to look at are liquidity and safety. Returns are not the most important factor, but is also worth considering as a final point. The options that fit these criteria are savings account, fixed deposit, liquid funds, and ultra-short term funds.

Of these, a mix of your savings account and a good portion in liquid funds works well. Since your contingency fund will be lying around for long periods of time, this will allow you to get the required liquidity and safety but still eke out some higher returns. You could also include some ultra short-term funds – while these are slightly riskier, they deliver higher returns and risks mitigate on holding beyond 6 months to a year. But take care in selecting ultra-short term funds as a few of them invest in low-quality debt which ups the risk factor.

Here’s why the mix above makes sense:

1. A savings account is the most liquid, as you can withdraw the money immediately. Redeeming from liquid funds is also easy, and you will receive the proceeds within 1 business day. Liquid funds don’t have exit loads either. Ultra short-term funds may have exit loads; redemption proceeds can also take a couple of days to land up in your account, so put a smaller portion here if you’re using them. Note that if you do not have the discipline to maintain a minimum savings account balance, it’s best to put more into liquid funds.

2. Liquid funds usually deliver returns higher than savings bank accounts. Liquid funds also stick to high-quality debt papers and don’t deliver even 1-day losses (barring extreme and rare circumstances). There isn’t any tax to be paid until you actually withdraw, so your money compounds much more. Savings bank interest (over Rs 10,000 a year) and fixed deposit interest are necessarily taxed each year, increasing your tax payouts and hurting compounding for your investment.

3. Capital gains on liquid and ultra short-term funds are taxed at 20% with indexation benefit on holding for more than 3 years (taxes are at slab rates for a holding period shorter than this). Regardless of holding period, savings account and fixed deposit interest are taxed at slab rates. Therefore, your eventual tax impact may also be lesser with liquid/ultra short-term funds.