Why Liquidity Is Important in Financial Planning

Role of liquidity in personal finance

Because liquidity is one important measure of your overall financial wellness, it’s something to consider in your financial planning. Here are a few examples of how liquidity could help.

Cash flow. We all have bills to pay, and having liquidity helps us to meet everyday cash needs and short-term financial obligations – whether we’re talking about groceries, car payments, rent or mortgage.

Emergency preparedness. Being able to tap into your cash reserve when dealing with life’s surprises (say, a leaky roof) can provide peace of mind. Having access to cash to handle an emergency means you’re less likely to have to tap into your investment accounts or take out a personal loan. The general rule of thumb is to have enough cash on hand to cover at least three to six months of living expenses.

Debt management. Maintaining the right balance of liquidity can also help you manage debt. For example, being able to pay your credit card bill in full and on time each month helps you avoid interest charges and late payments. If you have personal loans, making timely payments can help you avoid defaults.

Financial goals. When you’re liquid, you may feel you have more flexibility when it comes to making decisions about your financial goals. Liquidity allows you to be nimble and take advantage of timely financial opportunities as they come up. For example, let’s say you’ve been eyeing a new car and the borrowing terms have finally turned in your favor – you’ll need cash to put in that down payment and lock in your rate.

Figuring out your liquidity needs

Everyone’s liquidity needs will be different depending on your monthly expenses and financial goals. For instance, if you’re planning to buy a home in the near term, your liquidity needs may be higher. Mortgage lenders often assess your liquidity as part of the application process.

Also, in times of economic uncertainty, you may want to hold on to a little more cash in your bank accounts to help cushion any unexpected financial hits – like a sudden job loss.

Here are a few general tips to keep in mind as you assess your liquidity needs.

• Understand your financial needs and goals. It’s usually helpful to first take stock of your financial obligations and goals. Your immediate or short-term goals might include having enough cash on hand to cover everyday expenses and maintain an emergency fund. Longer-term goals could be paying down debt or saving for a vacation home.
• Assess your cash flow. A good next step is to calculate how much you’ll need to fund your goals and establish a timeline for each one. Remember, generally, you’d save for short-term goals and invest for long-term goals. And a short-term goal is typically anything you’re planning to achieve within a five-year period.
• Consider using accounts that make sense for your needs and goals. Money that you’ll need for everyday expenses and your emergency fund should also be kept somewhere safe and fairly accessible – like a checking or high-yield savings account. For money you don’t need right away, you may want to consider a certificate of deposit (CD) account. A CD typically offers a higher APY than a traditional savings account, but you’d have to keep your money deposited for a certain amount of time.

A quick word on investing and investment liquidity

If your cash reserve is solid – meaning you have an emergency fund in place as well as enough liquid assets to cover your everyday expenses and short-term goals – you may want to consider investing any extra cash for your long-term goals, which gives you an opportunity to potentially earn a higher return and combat cash drag.

Keep in mind, however, that investing involves risk. There are no guaranteed or predictable returns. Market volatility means you could make money, or you could lose money – including your principal.

While investments like stocks and bonds are considered liquid assets because they can be sold and turned to cash relatively quickly, this doesn’t necessarily mean they can provide the liquidity you need in an emergency. For instance, while you can sell your stocks almost anytime, doing so during an economic downturn could mean you’re selling them at a loss.

Again, if you have questions about how to properly build liquidity and find the right financial vehicles for your goals, talk to a financial advisor.