You may already be familiar with the concept of liquidity, which refers to how easily an asset can be converted into cash without losing significant value. Common examples of liquid assets include cash – like the money in your checking or saving accounts – as well as certain securities like stocks and bonds, depending on how quickly you can sell them on the market.
Understanding your liquidity needs is an important part of financial planning. Knowing how much cash you need to have on hand allows you to meet your financial obligations today and plan for your goals tomorrow – such as your retirement.
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.
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.
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.
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