What are the Benefits and Key Parameters of a Contingency Fund?
29 September 2022
A contingency fund consists of liquid assets, such as cash, investments, or even a combination of both. One of the main advantages of having a contingency fund is that it helps you avoid going into debt or borrowing money at high interest rates to meet unexpected expenses.
Understanding a contingency fund would require you to realize that we live in an unpredictable environment. Any situation can crop up at any time without warning. For instance, you may plan your finances so that your regular income covers all your monthly expenses. But what if you suddenly lose your job? What happens if you have planned a particular timeline for selling your products, but there is a sudden fall in demand due to unplanned factors?
In such cases, having some money set aside as a contingency fund can help you tide over the difficult phase without much financial stress. It works as a way to secure your financial plans and safeguard your position during phases of illiquidity.
Let us delve deeper into the importance of building a contingency fund.
What is a Contingency Fund?
A contingency fund is the amount of money set aside to deal with unforeseen and unexpected expenses. It acts as a cushion that can be used in financial emergencies like job loss, medical emergencies, etc. It is also an essential aspect for business owners to keep in mind as there is always an element of risk involved when running a business.
You must keep aside an amount equivalent to 3 to 6 months of your income or 6 months of expenses.
Importance of Contingency Fund
The importance of a contingency fund lies in the fact that it can provide you with much-needed financial support during tough times, so you can avoid unwanted debt or high-interest loans.
Apart from this, a contingency fund can also help you take advantage of opportunities that may come your way. You can respond quickly to opportunities and take action before they slip away. This is true for both investments and business ideas.
Ways to Create a Contingency Fund for your Business
If you are looking to create a contingency fund for your business, you can do so by following the given steps:
1. Analyse Your Business Needs
Take a look at your short-term and long-term business needs. Identify areas where there is a higher risk of unexpected expenses. Prepare a budget for your business and track your expenses. This will give you an idea of how to set aside money for your contingency fund.
2. Set Aside a Fixed Percentage of Your Income
Once you have made a budget, you can set aside a fixed percentage of your monthly income for your contingency fund. For instance, you can choose to put 10% of your income towards this fund.
3. Invest in Short-term Investments
Once you have accumulated some money in your contingency fund, you can invest this money in short-term investments like government or corporate bonds or even money market funds. This will help you earn some returns on your investment while keeping your money safe.
4. Review your Fund Regularly
Regularly check your contingency fund to ensure its adequacy.
What are the Advantages of a Contingency Fund?
Contingency funds have the following advantages:
1) It helps you deal with financial emergencies
A contingency fund can provide you with much-needed financial support during tough times without the need to resort to debt or high-interest loans.
2) It helps you take advantage of opportunities
A contingency fund can also help you take advantage of opportunities that may come your way. For instance, if you are planning to start a business, having some money set aside as a contingency fund can help you with the initial investment.
3) It protects you from taking on extra debt
If you have a contingency fund in place, you can use this money to deal with unexpected expenses instead of resorting to debt. This can help you avoid taking on extra debt, which can be difficult to repay.
4) It reduces your financial stress
Having a contingency fund can help you reduce your financial stress, as you know that you have some money set aside to deal with unexpected expenses. This can give you peace of mind and help you focus on other important things.
Things to Know About Contingency Fund
Here are a few other things that you must know about a contingency fund:
The size of your contingency fund should be based on your needs: The amount of money that you need to set aside as a contingency fund will depend on your needs. If you have a family, you may need to set aside a larger amount of money than someone who is single. Similarly, if you have a business, you may need to set aside a larger amount of money as compared to an employed individual.
Your contingency fund should be easily accessible: You should not invest this money in long-term investments that block your funds for long. Instead, you can keep this money in a savings account or a money market fund that is easily accessible.
A contingency fund is an integral part of financial planning. It can help you deal with financial emergencies and take advantage of opportunities that come your way. A contingency fund should be based on your needs and should be easily accessible. You should also review your contingency fund regularly to ensure that it is adequate for your needs. You can avail personal loans up to Rs.20 lakh starting at 9.9% p.a. Install the Navi app now!
FAQs on Contingency Fund
Q1. What is a contingency fund?
Ans:A contingency fund is an amount of money set aside to deal with unforeseen and unexpected expenses. It acts as a cushion that can be used in case of financial emergencies.
Q2. What are the advantages of a contingency fund?
Ans:Contingency funds are advantageous as they secure your financial future. Moreover, it helps you take up new opportunities without taking on any additional debt. This also reduces your financial stress.
Q3. How much money should I set aside as a contingency fund?
Ans:You must keep aside an amount equivalent to 3 to 6 months of your income or 6 months of expenses in your emergency fund.
Q4. Where should I keep my contingency fund?
Ans:You must keep your contingency fund in the form of liquid assets, such as cash. Keeping the funds in a savings account is also beneficial. If you invest it in liquid funds, you can earn interest on it too.
Q5. For what reasons would you need a contingency fund?
Ans:A contingency fund can be used in a financial emergency, or in case you want to jump in on a new opportunity, or even in cases when you want to take a break from work.
Before you go…
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Disclaimer: This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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