Do you want to know a secret? Many millionaires struggle financially. Often, it’s because they underestimate the importance of maintaining a sufficient liquid net worth. But what is liquid net worth? Why does it matter? Keep reading to find out!
In this article, you’ll learn:
- how to calculate your liquid net worth
- why your liquid net worth is an important number to track
- the consequences of having a low liquid net worth
- how to increase your liquid net worth
What is liquid net worth?
The term “liquid net worth” describes the portion of your net worth that you could convert into cash on short notice without incurring significant penalties (if any).
This includes physical cash along with money you keep in financial vehicles such as:
- savings accounts
- money market accounts
- taxable brokerage accounts
- certificates of deposit
Meanwhile, your liquid net worth excludes money tied up in financial vehicles such as:
- real estate
- cars
- private companies
- long-term investment accounts (i.e. a 401k)
It might take you several days (sometimes even weeks or months) to access money held in these assets. That’s why experts describe them as “illiquid.”
How to calculate your liquid net worth
The formula for calculating your liquid net worth is simple. Subtract your total liabilities from the value of your liquid assets. Alternatively, if you already know your total net worth, simply subtract the value of your illiquid assets from it.
For example, let’s say you have $100,000 in your 401k, $20,000 in cash, and $200,000 in home equity. On the liabilities side, you have a $300,000 mortgage balance and $10,000 in car loans.
In this scenario, your liquid assets are valued at $20,000. Your liabilities, meanwhile, total $310,000. Therefore, your liquid net worth is -$290,000.
Don’t panic if you have a negative liquid net worth
Having a negative liquid net worth isn’t necessarily a bad thing. After all, illiquid assets still offer financial benefits – especially if you’re able to keep money invested in them for the long haul (as intended with retirement accounts, for example).
Issues arise when your portfolio becomes weighted too heavily towards illiquid assets. Being house poor is a classic example. If your liquid net worth is negative because your home is the only substantial asset you own, you might be in trouble. If (like in the example I shared above) you have a negative liquid net worth yet still maintain a sizeable cash position, you probably don’t have anything to worry about.
A good rule of thumb is to maintain enough of a liquid position to cover between three and six months of essential expenses. Experts recommend this amount since it’s typically enough to protect you from common financial challenges, such as job loss. Later in this article, I’ll explain why you might want to increase your liquid net worth even further beyond that guideline. However, it’s a good starting point.
Why is having liquid assets important?
Having plenty of money available in liquid assets demonstrates your ability to weather short-term financial storms without taking on debt or being forced to sell illiquid assets at inopportune times.
To help you understand the importance of this, let’s examine a hypothetical scenario.
John and Sarah are neighbors. Both have net worths of $1 million. John’s net worth is split evenly between his house, retirement accounts, taxable brokerage accounts, and cash savings. Sarah’s net worth, meanwhile, is split evenly between her home and retirement accounts.
One day, a bad storm hits their city. Both John and Sarah experience basement flooding. Neither have insurance coverage for this.
Because John has a considerable portion of his net worth in liquid assets, he can cover the cost of repairs fairly easily (and without penalties).
Sarah, meanwhile, is in hot water. Because she has a low liquid net worth, none of her three main options are favorable:
- Withdrawing money from her retirement accounts, incurring taxes and early withdrawal penalties
- Taking out a home equity loan, which would be subject to approval by a lender and expose her home to the risk of foreclosure if she became unable to make repayments
- Receiving a loan from some other source, which would carry a higher interest rate than a secured home equity loan
Each of these options would also likely take more than just a few business days to execute.
My point? Despite having the same net worth, John and Sarah have very different levels of preparedness for short-term financial challenges. It all comes down to their liquid net worth (specifically, John’s abundance and Sarah’s lack of it).
Tips for increasing your liquid net worth
Next, let’s discuss how you can ensure you have enough liquid assets to avoid ending up like our friend Sarah from the above example.
Start with the basics – your emergency fund
As I mentioned earlier in this article, your emergency fund is a vital source of liquidity in hard times. I keep enough money in my emergency fund to cover essential expenses for eight months. That money lives in a savings account (separate from money meant for day-to-day spending) I can withdraw from within two business days.
Some people might consider that overkill, especially in today’s inflationary environment. However, I think of my emergency fund as a moat around my long-term assets. I don’t care if it loses value because the benefit of being able to keep money in my retirement and taxable brokerage accounts is far greater.
Reduce your liabilities
Amassing more assets isn’t the only way to increase your net worth. In fact, reducing your liabilities is an equally important consideration. If you have high-interest consumer debt, eliminate it using strategies such as the debt avalanche or debt snowball.
This won’t only increase your net worth. It will also reduce pressure on your liquid assets in the event of a financial emergency.
Beyond the prior two steps, think carefully about why you want more liquid assets
Once you have an emergency fund and a grip on your debt, think very carefully about whether it makes sense to increase your liquid assets. As I mentioned earlier, stacking as much money as possible into liquid assets isn’t necessarily a good goal.
One valid exception might arise if you’re an American looking to retire early. According to The Balance, the U.S. government generally doesn’t want you to make 401k withdrawals until age 55. If you plan to retire at 35, however, having the bulk of your retirement funds in a 401k may not provide enough liquidity. You may also need to invest much more than 401k contribution limits would allow.
On the other hand, if you want more liquid assets because you’re scared of long-term investing, that may not be a smart approach.
Work closely with a financial advisor to figure out how much money you actually need to keep liquid before proceeding.
Increase your income (and employability)
Regular income is a fantastic source of liquidity. After all, it’s a steady stream of cash that can be used to pay for essentials and cover the cost of emergencies.
Increasing your income won’t only leave you with more money to buy liquid assets with. If your income increases because you’ve gained new skills (or improve existing ones), you’ll also become more employable. As with paying off debt, this will reduce pressure on your liquid assets, freeing you up to invest more in illiquid assets (if that makes financial sense for you).
Sell illiquid assets
Sometimes, it makes sense to take drastic steps to increase your liquidity. If you’re house poor, for example, that might mean downsizing and investing the difference in liquid assets.
Take advantage of low-interest loans to pay for illiquid assets
These days, you can get very favorable mortgage and car loan terms. For example, I’m paying 1.09% interest on my car loan right now. Some banks offer mortgages at similar rates.
Taking advantage of loans like these can buy you more time to purchase liquid assets. Rather than rushing to pump more money into your car or home equity (remember, these are both illiquid assets), you could consider making minimum monthly loan payments and using any excess funds to increase your liquidity.
Conclusion
Your liquid net worth is a very important part of your financial future. I hope this article has helped you understand what your liquid net worth is, how to calculate it, and why it’s important. For more of my articles on the topic of financial planning, click here.
