When it comes to getting the most from your money, holding on to cash may not be the first strategy that comes to mind.
After all, when you have a solid cash reserve, why plant your bills in a savings account when you could potentially earn higher returns by investing in the stock market or purchasing a rental property?
Still, having liquid assets like cash is smart for any portfolio, especially during an economic downturn. Not only does cash come in handy for taking care of life’s unexpected expenses, it can also free you to take advantage of opportunities.
For example, if market conditions work in your favor and you want to buy stocks to add to your portfolio, or put in a down payment for a car that now has better lending terms – you’ll need cash for that.
To ensure that you have enough liquid assets on hand for your goals and financial situation, here are some things to consider.
When it comes to building liquidity, it’s usually worth taking stock of your financial needs and goals first.
Thinking about your cash goals in a time frame (short-term versus long-term) can help you determine how to divvy up your funds.
Your immediate or short-term goals might include having enough cash on hand to cover every day expenses or to build up an emergency fund if yours needs a boost. Longer-term goals could be saving for a vacation home, or socking away funds to start a new business.
After sizing up your goals, a good next step is to lay out how much cash you’ll need to fund each one.
For covering everyday expenses, financial experts recommend one to two months' worth of spending money plus a buffer of 25 to 30% of the balance in your checking account.
Next up comes your emergency fund. A solid emergency fund generally has about three to six months’ worth of living expenses, though you may decide to keep less in it if you’re part of a two-earner household or more if you're starting a family.
How much you’ll need for bigger, perhaps more long-term goals like buying property or new car, will depend on many factors, including your credit score, the market, and where you live.
A 20% down payment on a $500,000 home, for example, will be $100,000.
It’s likely that you’ll use different accounts for your various goals and financial needs. Before committing to a particular type of account, consider when you’ll need the money and how quickly you’ll want to withdraw it.
Checking accounts are a good place to keep funds for everyday expenses and regular bills because you can withdraw funds using a debit card, check, or electronic transfer, with fewer limitations than other types of accounts.
However, this flexibility comes with little – if any – interest-earning potential. Over the past decade, the average rate for interest checking accounts was approximately 0.05%.
For cash that you won’t need to access for a few months or are still in the process of building up – like saving up for a new car in the coming months or buying a vacation home in a few years – you might consider an account that earns more interest on your money, like a high-yield savings account, money market account, or certificate of deposit.
Your emergency fund can go into one of these accounts, too, or you could even split it up between accounts.
As of June 2020, the top rates on high-interest accounts from online banks were between 1.2% and 1.35% APY. The average APY for a one-year CD under $100,000 is 0.25% and 0.51% for a 5-year CD.
In exchange for higher interest rates, some of these accounts may limit how quickly you’ll be able to take out your money and how often. While some banks offer quick access to savings through ATM withdrawals, online transfers can take 1 to 2 business days, depending on your institution.
Traditional CDs, for example, allow you to lock in an interest rate, but you agree to not take out the funds without penalty until a certain amount of time has passed, typically from six months to a few years. Still, CDs can be a good place to sock away funds for goals that are months or years away.
For instance, if you plan to buy a vacation home in several years, and want to designate an account to hold those funds while earning more interest, then a CD may be a good option.
Since you usually can't remove partial funds from a traditional CD and you’re subject to a maturity date, these accounts can be a good option for time-bound goals and take away the temptation of withdrawing funds early to splurge on something else.
Savings vehicles are liquid and secure places to keep your money for your various shorter-to-medium term goals.
But if your cash reserve is solid – meaning you have an emergency fund in place as well as assets to cover your financial goals – investing whatever is left can offer the potential to maximize returns and combat cash drag.
Cash drag happens when inflation outpaces your current interest rate. This is more likely to occur when you have excess money in lower-yield accounts.
While investing involves more risk, it can come with higher earning potential. For example, the average annual return for the S&P 500 since its inception in 1957 through 2018 was about 8%, while the average inflation rate hovers between 1 to 3%.
That doesn’t mean your investments are guaranteed to grow every year – you may even lose money in years of volatility or during a recession – but if you’re patient through the ups and downs of the market, you may see an overall increase.
But keep in mind this feature doesn’t mean they’re necessarily the right place for money you’ll need for your financial goals. Investments can vary day-to-day based on market conditions, so you could lose money on your investments if you have to sell them for cash during a downturn.
Retirement accounts, like a 401(k) or IRA, are usually only considered liquid if you’re of retirement age. While you may be able to withdraw funds from these accounts sooner, you’ll usually be required to pay income tax and an early-withdrawal penalty of 10% of the amount withdrawn.
It’s best to avoid touching these long-term funds unless absolutely necessary.
One important note: Rules changed a bit during the Covid-19 pandemic, so check with your HR department, account manager, or financial advisor to confirm what penalties are in force.
Ultimately, finding the right mix of having quick and easy access to cash and maximizing earning potential comes down to your needs, goals, and comfort level.
If you're unsure of how to properly diversify your liquidity, consider talking to a financial adviser who can help you come up with the best cash composite for your financial picture.
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