What is liquidity? An easy guide for families
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When it comes to learning about money management, one term that you may have heard of is liquidity. But, what does it mean, exactly? And how do you explain this concept to your kids?
Below, we break down what liquidity is plus the different types of liquidity that are important to understand for a better picture of your household’s financial health.
What is liquidity?
Liquidity is a financial term that tells you how easily you can convert something into cash. There are varying levels of liquidity, and understanding how it works can help you manage your finances.
Why liquidity is important to understand
Families have recurring expenses every month, and they pay for these with cash or some form of cash equivalent, like a credit card. As long as they stick within their budget, they likely won’t have any issues coming up with the money to pay these bills.
But, what if something unexpected happens, like a medical emergency or a necessary repair to your house or car?
This is where it’s smart to build an emergency fund, so that you have access to additional cash quickly to pay for these things, but if they don’t have an emergency fund or the fund isn’t large enough, you need to come up with other ways to fund the unexpected.
Using an app like Greenlight, which helps you track your money and set savings goals, is a great way to help you build an emergency fund.
Knowing what types of assets you have, how quickly you can sell them for cash, and how much cash you can expect to receive in return for selling them can help you know what to do in these situations.
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Typically, the more liquid an asset, the faster you can sell it for a fair value. If something is illiquid, you may still be able to sell it quickly, but you may need to sell it at a deep discount from what it’s really worth to do so.
Types of liquidity
There are several ways to measure liquidity, including:
Market liquidity
How easily you can sell something on the open market for a fair price.
Example: You’re trying to sell a concert ticket on a resale app. If it’s for a sold-out Taylor Swift concert tomorrow, it’ll sell quickly and probably for market value, or maybe even more. That’s high market liquidity. If it’s for a local band that’s not very well known, it may take a few days to sell and you may get less than you paid for it. That’s low market liquidity.
Everyday assets ranked by market liquidity:
High: Cash, stocks, government bonds
Medium: Gold, mutual funds
Low: Houses, cars, art, collectibles
Accounting liquidity
How easily a person or business can pay their bills and short-term debts.
Assets families may use to determine their accounting liquidity include:
Cash in their checking/savings account and emergency fund
Money they are owed, such as their weekly paycheck or from a freelance gig
Things they could quickly sell, like a used iPhone
In simple terms, this helps answer the question, “If we had to pay all of our bills right now, could we?”
Funding liquidity
How easily you can borrow money or access credit when needed.
Example: Your car breaks down and you need access to money to fix it. If you have a good credit score and can get a low-interest loan quickly, you have high funding liquidity.
In emergencies, your ability to quickly access funds can be a safety net, even if you shouldn’t rely on these methods long-term. This can also include credit cards and home equity lines of credit.
Why your household needs liquidity
Liquidity, or your ability to access cash quickly when needed, is helpful for a few reasons:
Stability: Avoid taking on debt or not being able to handle an emergency when it arises.
Flexibility: Take advantage of opportunities, such as travel deals, purchasing a car with cash, or putting a down payment on a rental property that’s selling for below-market value.
Peace of mind: Know that you don’t have to worry about your finances, even if something unexpected happens.
How to build your liquidity
To keep your money accessible and increase your liquidity, you can:
Build an emergency fund. Work your way up to 3 to 6 months of expenses saved in cash, so you can handle any emergency or even losing your job.
Don’t tie up all your money in the stock market. The stock market goes up and down in the short term, and you don’t want to be forced to sell your investments at a loss because you don’t have access to any other cash. But at the same time, don’t keep all your money in cash, so you can continue to build your long-term wealth.
Don’t tie up all your money in illiquid investments. The same goes for putting all of your money into things like houses, real estate, art, and collectibles. While they may have value, you don’t want to be forced to sell them at a steep loss if you need cash.
Follow a budget and track your money. Knowing where all of your money is going at all times and sticking to a plan helps you stay prepared for unexpected financial needs.
FAQs
Can you have too much liquidity?
Yes. If you have too much money sitting in cash, you may be missing out on investment opportunities and ways to grow your money for the future. Aim to have a healthy balance between short-term liquidity and long-term growth.
Are stocks always liquid?
Stocks of well-known companies that are actively traded are usually highly liquid, meaning you will be able to quickly sell for their current market value. But if the stock market is performing poorly or you hold a stock in a lesser-known or lowly traded company, it may take longer to sell or you may need to sell it for below market value.
Is my savings account considered liquid?
Yes, you can access money in a savings account very quickly with no penalty.
Are retirement accounts like 401(k)s liquid?
Yes, but 401ks are not highly liquid because although you can access the money fairly quickly, you will typically pay penalties and taxes for withdrawing the money early.
What’s the least liquid thing I might own?
Probably your house because real estate may take weeks or months to sell, depending on the market. If you need to sell quickly, you may also have to take less than the market value in addition to any closing costs and realtor fees.
How much liquidity should a family have?
A good rule of thumb is to maintain 3 to 6 months of expenses in an emergency fund, so you can easily access it.
Do credit cards count as liquidity?
If you have access to nothing else, credit cards can fund an emergency, but they often have very high interest rates. So, if you can’t pay them back quickly, that emergency could become much more expensive as the interest adds up.
Keeping it simple
Liquidity can be seen as a highly complex financial term, but understanding how it applies to your family’s financial household can help you make smarter and more confident financial decisions going forward.
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