Financial planning includes individuals providing for unknown contingencies. In conversations about consideration for emergencies, people often mention emergency funds and contingency funds. Although they sound the same, their purposes, usages, and structures differ. Knowing the clear understanding of differences can assist individuals in organizing their finances without unnecessary emotional disturbances in periods of financial distress.
What are emergency funds?
Individuals reserve emergency funds specifically for unplanned, urgent, and unavoidable expenses. Common examples include medical emergencies, temporary job loss, and repairs required for house damage. People can easily access the amounts under these sets without using credit or loans. They usually keep these funds in the form of liquidity, such as a savings account or liquid mutual fund, because individuals want to be ready to act immediately. That makes it necessary for these funds to exist to reduce reliance on borrowing during times of emergency.
What are contingency funds?
Contingency funds pertain to financial contingencies that are not urgent but possible. A reduction in salary, relocation expenses, litigation costs, or a family obligation is included in this list. In contrast to emergency funds, individuals use contingency funds for events that are not immediately present but manifest in changing circumstances.
Main differences between emergency and contingency funds
Emergency funds serve unforeseen immediate mishaps that need instant financial solutions; therefore, these are short-term reserves of very high liquidity, usually in savings accounts or liquid mutual funds. Individuals set aside contingency fund reserves for future occurrences that might happen, though not immediately. Reserves may build up over time and remain in short-term debt instruments, fixed deposits, or mutual funds with low to medium volatility.
While emergency funds address urgent issues such as medical expenses or job loss, contingency funds cater to smaller fires that could arise from less immediate scenarios, such as relocation for work or career transitions. Along similar lines, liquidity differs. Emergency funds demand immediate access, while contingency funds can allow slightly reduced access for stable, bright returns. In both cases, however, the result is financial well-being protection, but it is defined differently due to urgency and reason.
How do mutual funds contribute to the construction of these funds?
The role of mutual funds involves managing these two types of funds. Investors use liquid or ultra-short duration mutual funds for emergency funds due to their liquidity and low volatility, allowing them to easily redeem the units one day in case of emergencies. A systematic withdrawal plan in mutual funds can also be considered for contingency funds, as it allows investors to withdraw amounts in a planned manner without disturbing the core investment.
For example, an investor can choose an option with a slightly longer duration and maximum possible yield for contingency funds since these funds are not likely to be called for use in an immediate period. Examples include short-duration mutual funds, low-duration funds, or arbitrage funds.
Building emergency and contingency funds
The whole process begins with individuals assessing their expenses. In the case of emergency funds, essential monthly expenses include rent, groceries, utility bills, and EMIs. Individuals determine the total amount required by applying a multiplier factor to these expenses.
For contingency fund valuation, individuals consider changes in lifestyle as they anticipate events in their lives. For instance, if a person expects to start a business in the next two years, the contingency fund is meant to cater to both personal and business expenses in the initial months of operation.
Both types of funds should remain separate from regular savings and investment portfolios. Mixing these can lead to confusion and may result in the premature use of money intended for specific purposes.
Monitoring and adjusting the funds
People’s circumstances change around them over time: salaries go up, responsibilities grow, and financial goals change. Thus, reviewing both emergency and contingency funds at periodic intervals is essential for maintaining their adequacy. With inflation, all financial plans, including these funds, change in value. What seems sufficient today may no longer be so in a few years. That is why it is necessary to monitor regularly and top up according to current needs.
Conclusion
Besides reserving certain cash for emergencies, both emergency funds and contingency funds address different but complementary dimensions in personal finance. The emergency fund mitigates shocks from sudden financial disruptions while limiting anticipation and preparing individuals for uncertain events that might occur.