Sometimes you may do everything that is necessary to ensure your financial safety, but certain situations may take you out of your comfort zone. There may be a financial emergency such as hospitalization of a family member, loss of a job, or any other such uncertainty. During such critical times, having enough funds is key. Being prepared for any kind of emergency gives you confidence to tackle the situation and stand strong.
For instance, Mr. ABC was planning for a family vacation this winter. However, last week his wife met with an accident and his plans went down the drain. He had to arrange funds for the sudden medical expenditure.
In short, as rightly said by Noel Whittaker-
“Life is full of uncertainties. Future investment earnings and interest and inflation rates are not known to anybody. However, I can guarantee you one thing… those who put an investment program in place will have a lot more money when they come to retire than those who never get around to it.”
In this situations like Mr. ABC’s, the financial goals that we dream off—such as a cozy retired life, giving the best to our children – be it education or even preparing for their marriage—may all go haywire due to an emergency expenditure. A high financial exodus may even affect day-to-day spending to run a home, including servicing EMIs for a home loan.
To be prepared, you need to start by building your contingency reserve and make sure you are adequately insured.
So, what is a contingency fund?
A contingency fund, also known as a contingency reserve or emergency fund, is savings that you set aside for a financial emergency.
How much do you need to save for a healthy contingency fund?
| Contingency Reserve = 6 to 18 months of living expenses |
Well, it is best to maintain a contingency reserve of minimum 6 months of monthly expenses to a maximum of 18 months. This will enable you to cover expenses in case a contingent event does occur.
While creating a contingency reserve, consider all unavoidable expenses, such as household expenses that fund your basic needs, utilities, medical expenses (if you or your family member is on regular medication), travel expenses, EMI on loans, and children education expenses.
You see these expenses are to be paid even if there is loss of income, or no income.
Options to maintain your Contingency Reserve
Safety and liquidity should be your priority. Contingency funds are meant for emergencies. Returns are secondary. You see, money needs be available within 24 to 48 hours whenever necessary. Accordingly, you may consider various avenues to put money aside for your contingency needs. Some of the prominent options are…
- Recurring Deposit
- Sweep-in Account
- Bank Fixed Deposit
- Cash in Bank
Let us now dwell a little deeper and understand the conventional ways of maintaining your contingency reserve through mutual funds…
Maintaining your Contingency Reserve through Mutual Funds
Mutual funds offer you a variety of options targeted towards various investment objectives. Likewise, some categories of mutual funds invest in instruments of very short duration and are suitable to maintain one’s contingency reserve…
Liquid or Money Market Funds
You can use liquid funds to park a portion of your contingency fund. These funds invest in money market instruments and are suitable even for a short-term investment horizon of less than 90 days. As most liquid funds do not have any exit load, you can exit any day, without any penalty. On withdrawal, the redemption proceeds are credited to your bank account within 1-10 days.
Liquid Plus or Ultra Short-Term Debt Funds
Ultra-short-term debt funds invest in instruments with higher duration’s as compared to liquid funds. As the duration is slightly higher, the risk is slightly higher as well; but they have the potential to yield higher returns than those clocked by liquid funds. While most of these funds do not carry exit load, there are some ultra-short-term debt funds that have an exit load period of 7 to 30 days. Hence, money that may not be required within 3 to 6 months can be kept in these funds.
Floating Rate Funds
They aim to generate returns in line with the prevailing interest rates and are suitable to hedge your corpus against interest rate risk. While these funds carry a lower interest rate risk, they are meant for investments with a time horizon of around 6 to 12 months.
Short Term Debt Funds
If there is a portion of your savings that remains untouched for long, say the next 12 to 24 months, Short Term Debt funds invest in instruments with a duration of around 1 to 2 years, and hence can be considered where the investment horizon is of around 1 to 2 years. Remember that many short-term debt funds may attract an exit load if withdrawn within 6 to 12 months. So, you need to plan accordingly.
To Sum Up
Probably, when you first considered setting aside 6-18 months of expenses as a contingency fund, it might have seemed a large sum of money. In time, you will feel this contingency fund is just lying idle, and you could miss out on what it would earn if deployed into other asset classes. However, now you can deploy your savings into mutual fund schemes that give you higher post-tax returns and are as flexible as savings deposit.
Happy Investing!
Source: Personalfn.com | MF Learning | Dec. 05, 2017
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