Managing Liquidity: How Much Cash Do You Really Need?

With the current economic uncertainty and new global conflicts seeming to happen every day, checking your overall liquidity level is crucial. Protecting your family’s financial well-being has never been more important. Business investment and consumer spending have slowed due to the high interest rate environment. Labor markets are softening, and layoffs are on the rise.

But how much cash do you really need to weather the storm? Is there a point where too much liquidity prevents you from building wealth? Read on to learn more about managing liquidity.

Understanding Emergency Funds

1. How Much Should You Set Aside for an Emergency Fund?

An emergency fund is cash set aside in one or multiple accounts to cushion the blow during unexpected life events. One of the most important aspects of your emergency fund is that you can access the money quickly to cover expenses.

If you suddenly find yourself out of work, or if your self-employed business takes a hit, you need a comfortable runway until your income returns. This way, you won’t have to dig into long-term investments or take on debt. You need cash savings to cover your essential monthly expenses without any additional income.

For a single-income household, experts recommend saving at least six months’ worth of expenses. In a dual-income household, three to six months is generally advised since the odds of both incomes disappearing simultaneously are lower.

Using the “Emergency Fund Ratio” or “Basic Liquidity Ratio” helps you understand how many months you have covered. Calculate your cash (or near cash, i.e., funds accessible soon) and divide that total by your monthly essential expenses. Essential expenses include both fixed and variable costs that can’t be easily cut back. Discretionary expenses that can be eliminated from your budget don’t need to be included.

For example, if your household’s monthly essential expenses—like rent/mortgage, groceries, student loan payments, insurance, and utilities—total $7,000, and you want your emergency fund to cover at least four months, you would need $28,000 saved.

If you’re unsure, check out an emergency fund calculator like this one to find the number that fits your unique household needs.

Allocating and Automating Your Liquid Funds

2. Properly Allocate and Automate Your Liquid Funds

While there isn’t a set rule on where to keep your emergency fund, a great question to ask yourself is, “What’s the fastest and easiest way for me to access this money when I need it?” However, you’ll need to consider the trade-offs between speed and higher interest yields when choosing where to put your funds.

Most households start with a checking or savings account. For those building up more emergency savings, setting up automatic recurring contributions is a great way to stay on track. This way, you won’t have to remember to send money manually every week or month until you reach your target goal.

In the current environment, safe, high-yield savings accounts (HYSAs) operate as “near cash” with high interest rates. With higher returns, your money will grow faster than in a traditional savings account. Some HYSAs offer annual percentage yields (APYs) over 5%, which is more than ten times the average traditional savings account APY of 0.45%. HYSAs are insured up to $250,000 by the Federal Deposit Insurance Corporation (FDIC), making your money as safe as it would be in a traditional savings account. You can find options with no fees or minimum opening or balance requirements.

The main drawbacks are fluctuating interest rates and the fact that HYSAs are usually offered by online platforms rather than brick-and-mortar banks. This may mean it takes a day or two to access funds, although some platforms offer ATM card access. There are a few HYSAs with a brick-and-mortar presence, such as Capital One 360 Performance Savings, currently offering a 4.25% APY.

It’s important to note that money in your emergency fund isn’t designed to be a riskier investment. It’s meant to hedge against unforeseen events that can happen to anyone. Investments carry a certain amount of risk, and when it comes to having cash on hand for emergencies, you don’t want to risk those funds. This could result in not having enough money to cover the emergency when it happens.

That said, you also don’t want to miss opportunities to earn more with alternative “near cash” sources that are less immediately accessible. A two-fold approach is optimal: keep a smaller portion in an account you can access quickly, and keep the larger portion elsewhere for larger life events.

In addition to checking, savings, and HYSAs, consider alternative sources like Money Market Deposit Accounts, Certificates of Deposit, Money Market Mutual Funds, Asset Management Accounts, Treasury Bills (T-Bills), and US Series EE Bonds. These options offer advantages such as fixed rates or exemptions from state and local taxes. To determine the best place for your money, check out the chart below to weigh the pros and cons of each alternative.

Boosting Short-Term Liquidity

3. Tap Additional Options to Boost Short-Term Liquidity

In addition to a core emergency fund, knowing that you have backup options can provide greater peace of mind.

Selling securities or stocks is an immediate source of cash. However, the trade-offs include forfeiting potential asset growth, possible brokerage fees, and incurring capital gains tax.

Securities-based loans may take a couple of weeks to secure but can offer substantial liquidity. The major risk is that if the value of the underlying securities declines significantly, you may need to provide additional collateral or repay the loan immediately, possibly triggering a margin call.

Mortgage refinance with cash out is an option for homeowners with home equity to tap. You can access a large amount at a relatively low interest rate, but there are downsides. If you locked in a historically low interest rate when you purchased your home, you may not want to refinance at a higher rate. This process can also take a month or two.

A home equity line of credit (HELOC) is popular today because it doesn’t require refinancing your mortgage. Instead, you receive a relatively large line of credit (up to $1,000,000, depending on your loan-to-value ratio) with a 10-year draw period and low monthly payments over a 30-year payback period. Securing a HELOC can take 30+ days and involves a lot of paperwork. However, the interest may be tax-deductible if you use the funds for home improvements. If you shop around, you can find credit unions offering HELOCs at rates below the current 8.5% prime rate. For example, Fremont Bank is currently offering a competitive variable rate with a 5.99% intro rate for 6 months.

Unsecured loans or personal loans are also an option, particularly if you have high credit scores and can secure relatively low interest rates. These loans typically take a couple of weeks to obtain and have varied payment terms, often with shorter timeframes.

Assessing Your Overall Liquidity Health

4. Check Your “Liquid Net Worth” for Overall Liquidity Health

Businesses regularly check their liquidity health, and households should do the same. After all, you’re in a partnership committed to the venture of life. According to Investopedia, liquidity is “the efficiency or ease with which an asset or security can be converted into ready cash without affecting its market price.”

With greater liquidity, your household can easily meet financial obligations. However, too much liquidity comes with an opportunity cost. Some experts argue that “the need for liquidity is overrated” for financially competent households.

A good way to strike a balance is to check your liquid net worth. Calculate this ratio by taking your total cash (and near cash equivalents) and dividing it by your total net worth (assets minus liabilities).

For example, if you have $150,000 in cash and cash equivalents (assets easily converted into cash) and your total net worth is $1,000,000, then your liquid net worth is 15%. Some experts suggest aiming for 10 to 20%, especially if you are risk-averse. In certain situations, such as nearing retirement, it’s better to be conservative. Households with fixed incomes and a large portion of net worth tied up in their principal residence should consider this.

Other experts say that 5 to 10% is sufficient unless you’re highly leveraged. If your liquidity percentage is much higher, you may have excess liquidity. In that case, consider reallocating funds to take advantage of wealth-building opportunities in longer-term investments. Ultimately, it comes down to adjusting to your household’s level of risk tolerance.

Bottom Line and TLDR Action Items

Whether we want it to or not, there will come a time when we need funds to cover whatever life throws at us. Having a fully funded emergency fund in place is a great way to turn unexpected expenses into a smaller financial headache. With cash set aside, you can move past these problems without missing a beat financially.

1. Use the “emergency fund ratio” to assess how much to set aside.

Calculate your cash (or “near cash” equivalents) and divide by your household’s monthly essential expenses. This gives you the number of months you can cover. Single-income households should target at least six months. Dual-income households should cover at least three to six months.

2. Properly allocate and automate your liquid funds.

Start with a checking or savings account, but consider a high-yield savings account to take advantage of current 5+% Annual Percentage Yields (APY). Explore alternative sources like Treasury Bills (T-Bills) or Money Market Mutual Funds & ETFs for guaranteed fixed rates or exemptions from state and local taxes.

3. Tap additional options to boost short-term liquidity.

In addition to a core emergency fund, knowing you have backup options can provide peace of mind. Weigh the pros and cons of selling securities, securities-based loans, mortgage refinance with cash out, a home equity line of credit (HELOC), or unsecured loans.

4. Check your “liquid net worth” for overall liquidity health.

Strike a balance between having immediate cash and opportunities for building longer-term wealth. Calculate liquid net worth by taking your total cash (and “near cash” equivalents) and dividing by your total net worth (assets minus liabilities). Aim for at least 10 to 20% in liquid net worth if you’re risk-averse. For others, 5 to 10% liquid assets may be sufficient for comfort. If your percentage is much higher, consider reallocating funds to seize wealth-building opportunities. Adjust to your household’s level of risk tolerance.

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