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Why you should have a contingency / emergency fund

Emergencies come without any notice. It is always better to be prepared for them financially. An emergency or contingency fund is the way to go. Here’s all you should know about such a fund – the “what”, “why”, “how” and “how much” of an emergency fund.

What is an emergency or contingency fund?

This is a fixed amount that you have kept aside to take care of any unforeseen, urgent situation.

It is an amount that you specifically earmark for this purpose, and do not use for any other need. This is important – this amount is strictly meant for emergencies, nothing else.

Why should you have an emergency or contingency fund?

Anyone can face an emergency or a crisis. The last thing you would want to worry about at such a time is money! So, it pays to be prepared financially to face any such situation.

The emergency can be of any kind – a medical emergency (say you need money urgently for your mother’s operation), an accident (which can force you to take leave without pay for some time), a job loss (in which case you would need some money till you find another job), etc.

A fund earmarked as an emergency or contingency fund would not only provide financial stability during such a time, it would also provide you tremendous peace of mind so that you can focus fully on the problem at hand.

Characteristics of an emergency or contingency fund

The single most important feature of an emergency or contingency fund is liquidity.

Since this is the money you have saved for an unexpected incident, you would always need it at a short notice. Therefore, it is extremely important that this money is invested in liquid avenues – a place where you can get back you money without any delay.

Of course, it would be great if you can also get a good rate of interest on this money!

How should you save for an emergency or contingency fund?

Savings Account

Since liquidity is the single biggest criteria, the very first option is to keep it in a savings account in a bank. It is the most liquid investment avenue – but it would give you a very low interest rate (usually around 3.5% per annum).

Bank Fixed Deposit (FD)

Another option is to park this money in a bank fixed deposit (FD). A bank FD is not as liquid as a savings account, but you should be able to break an FD in a day at most banks.

Please be aware that there might be a slight penalty for breaking an FD, but let’s remember that this is money meant for emergencies – and we hope we never have to use it for that!

An FD would give you a reasonably good rate of return, with only slight compromise on liquidity.

Hybrid Account / Auto Sweep Facility for FDs

I would term this as the best option to invest the money for an emergency or contingency fund.

(Please read “Auto Sweep Facility: Smart way to make your money work harder” to know more about these accounts)

In a nutshell, these accounts provide the liquidity of a savings account, but at the same time, they provide the higher interest rates of FDs.

Thus, a hybrid account or an account with an autosweep facility would be the best way to invest the money for your emergency or contingency fund.

How much should you save for an emergency fund?

Well, it really depends on your comfort level. It’s the money that would make you feel safe and provide you peace of mind during times of trouble, so only you can decide how much is enough for you.

Having said that, the general consensus is that a contingency fund should be equal to 3 – 6 months income.

How can you save for a contingency fund?

Since the amount needed to be saved for this fund would be quite large, it is very natural that you ask this question!

You would have an easy solution if you have got some lump-sum money as arrears or bonus. That way, you can create this fund in one go.

(Please read “Don’t blow away a windfall – Smart ways to spend your bonus and arrears” to know how you can prudently spend a lump sum amount)

But you can create this fund over time from regular savings even if you are not getting any large amount in the near future. Please read “Goal Based Investing” to know how you can gradually build this corpus.

So, what are you waiting for? Save up for a contingency fund, and have one thing less to worry about during your emergencies!

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