Your car gets a flat tire. Your child accidentally breaks a window. Whatever the case may be, you now suddenly have an unexpected bill. Life happens. Having an emergency fund in place makes this new expense less of a financial problem, and more of a minor inconvenience.
With the current economic uncertainty and new global conflicts seeming to happen every day, checking your overall liquidity level is that much more important to protect your family’s financial well-being. Business investment and consumer spending have slowed as a result of the high interest rate environment, with labor markets softening and layoffs on the rise.
But how much do you really need in cash to weather the storm? And is there a point where too much liquidity keeps you from opportunities to build wealth?
Read on to learn more about managing liquidity, or for the summary jump to the TLDR action items.
1. How much should you set aside for an emergency fund?
An emergency fund is cash that you set aside into one or multiple accounts that helps cushion the blow in the event of unexpected life events. One of the most important aspects of your core emergency fund must be that you can access the money fast to immediately cover expenses.
If you suddenly find yourself out of work tomorrow, or if you’re self-employed and your business takes a hit, you need to have a comfortable runway until your income returns, so you won’t have to dig into long-term interest-bearing investments or take on debt. So you need cash savings to cover your monthly essential expenses without any additional income.
For a single income household, many experts recommend having at least six months’ worth of monthly expenses saved. If you have a dual income household, then three to six months’ worth of monthly expenses is the general rule of thumb since the odds of having two incomes disappear at the same time is lower than one.
Using the “Emergency Fund Ratio” or “Basic Liquidity Ratio” is a good way to know how many months you have covered. Calculate your cash (or near cash, i.e., funds accessible in the near term) and divide that total by your monthly essential expenses. Those essential expenses should include both fixed and variable expenses that can’t be easily cut back. You don’t need to include discretionary expenses that you can easily cut out of your budget.
So, for example, if your household’s monthly essential expenses such as rent/mortgage, groceries, student loan payments, insurance, and utilities are $7,000 each month, and you want your emergency fund to cover at least four months, then you would need $28,000 saved into your emergency fund.
If you’re still unsure, check out an emergency fund calculator like this one to help find the number that fits your unique household needs.
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 be able to access this money when I need it?” However, you’ll need to consider speed versus higher interest yield trade-offs when you choose where to put your funds.
Most households start with a checking or savings account. For those building up more in emergency savings, a great way to stay on track and grow this account is to set up automatic recurring contributions so that you don’t have to remember to send money manually every week or month until you reach your target goal.
In the current environment, there are safe, high-yield savings accounts (HYSAs) that operate as “near cash” with high interest rates that you should take advantage of. With higher returns, your money will grow faster than in a traditional savings account. There are HYSAs with annual percentage yields (APYs) over 5%, which is more than 10 times the average traditional savings account APY of 0.45%. With HYSA accounts insured up to $250,000 by the Federal Deposit Insurance Corporation (FDIC), your money is as safe as it would be in a traditional savings account. You can find one with no fees or minimum opening or balance requirements.
The main drawbacks are that the interest rates are fluctuating and HYSAs are usually offered in online platforms, rather than brick-and-mortar banks, so it might take a day or two to access funds. Though you can find platforms offering ATM card access. There are, however, a few HYSAs with brick-and-mortar bank presence (e.g., Capital One 360 Performance Savings is one of the few HYSAs from a brick-and-mortar bank currently at 4.25% APY).
It’s important to also note that money in your emergency fund isn’t designed to be a riskier investment. It’s designed to hedge your risks against unforeseen events that happen to everyone. Investments carry a certain amount of risk, and when it comes to having cash on hand for an emergency, you don’t want to be risking those funds, as this could result in not having enough money to cover the emergency when it happens.
With that said, you also don’t want to forego opportunities to earn more with alternative “near cash” sources that are not as immediately accessible. A two-fold approach is optimal where you keep a smaller portion in an account you can access on a moment’s notice, and then keep the larger portion elsewhere if a larger life event takes place.
In addition to checking, savings, and HYSAs, there are alternative sources such as Money Market Deposit Accounts, Certificates of Deposit, Money Market Mutual Funds, or Asset Management Accounts, Treasury Bills (T-Bills), US Series EE Bonds, that offer other advantages such as fixed rates or exemption from state and local taxes. To figure out the best place for your money, check out the chart below to weigh the pros and cons of each alternative.
3. Tap additional options to boost short-term liquidity
In addition to a core emergency fund, knowing that you have additional options as back-up can give households greater peace of mind.
Selling securities / stock is an immediate source of cash. The tradeoffs are that you may be forfeiting potential asset growth, there are possible brokerage fees, and you will incur capital gains tax.
Securities-based loans may take a couple weeks to secure, but can offer large amounts of liquidity. The major risk is that if the value of the underlying securities declines significantly, you may be required to provide additional collateral or repay the loan immediately, possibly evoking a margin call.
Mortgage refinance with cash out is an option for homeowners that have home equity to tap. Though a large amount can be tapped at a relatively low interest rate with debt secured by your home, there are several downsides. If you were lucky enough to lock into a historically low interest rate upon purchase, you won’t want to refinance into a higher rate for the balance. It can also take a month or two to obtain.
A home equity line of credit (HELOC) is popular these days, as it does not require refinancing your mortgage. Instead, you get a relatively large line of credit (can even be up to $1,000,000 and dependent on your loan-to-value ratio) with a 10-year draw period (open to draw upon as needed) and low monthly payments with a 30-year payback period. It can take 30+ days to secure and includes a lot of paperwork. But 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 for percentage points below the current 8.5% prime rate. (For example 1st United Credit Union is currently offering a variable rate at 2% below prime, or 6.5%).
Unsecured loans or personal loans are also an option particularly if you have high credit scores and can lock in at relatively low interest rates. These take a couple weeks to secure and have varied payment terms, often with shorter timeframes.
4. Check your “liquid net worth” for overall liquidity health
Businesses check their liquidity health on a regular basis and households should too, after all you’re in a partnership committed to the venture of life. The definition of liquidity, according to Investopedia, 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. But too much liquidity comes at an opportunity cost. In fact, some experts go deeper to explain how “the need for liquidity is overrated” for financially competent households.
A good way to strike the balance is to check your liquid net worth. You calculate this ratio by taking your total cash (and near cash equivalents) and divide by your total net worth (or assets minus liabilities).
So 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 you have a liquid net worth of 15%.
Some experts say that you should be at 10 to 20%, particularly if you are risk averse. In certain situations, it’s better to be on the conservative side, such as in retirement or when retirement nears. It can be when households have fixed incomes and a large chunk of net worth tied up in their principal residence. Other experts say that 5 to 10% is sufficient, unless you’re highly leveraged.
If you have a much higher percentage of liquidity, you may have excess liquidity and should consider reallocating funds to take advantage of wealth-building opportunities in longer-term investments. At the end of the day, 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’s going to 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 these unexpected expenses into a smaller headache financially than what they would be otherwise. By having the cash set aside, you can move on past this problem without missing a beat financially.
1. Use the “emergency fund ratio” to assess how much to set aside
Calculate how much you have in cash (or “near cash” equivalents) and divide by your household’s monthly essential expenses. This gets 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). Consider alternative sources such as Treasury Bills (T-Bills) or Money Market Mutual Funds & ETFs to take advantage of guaranteed fixed rates or exemption from state and local taxes.
3. Tap additional options to boost short-term liquidity
In addition to a core emergency fund, knowing that you have additional options as back-up to boost liquidity can give households greater peace of mind. Consider options by weighing 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 or personal loans.
4. Check your “liquid net worth” for overall liquidity health
Strike the balance between having immediate cash with 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 (or 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 take advantage of wealth-building opportunities. Adjust to your household’s level of risk tolerance. The Certified Financial Planners at JointGoals can help.