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Understanding Liquidity

February 5th, 2010 Leave a comment Go to comments

In this post I talk about liquidity and how to use it in your own finances.

The idea for this post came from one of my friends who is making a pretty large error in his personal finances. He is borrowing one of Suzie Orman’s big ideas: pay off your mortgage as soon as you can by prepaying principal and once it is paid off leave it un-leveraged. This isn’t a bad idea in itself, but he is structuring his finances toward this goal to the detriment of other parts of his financial life.

The other big issue in his life is his job security. Over the past few years, his job has been under threat due to global competition which has increased his anxiety as well as resulted in lower job quality and smaller pay over time. He is working on this issue by getting a certification and actively using his network to plan ahead for the next position (this is good).

This is the second time around, though this time he hasn’t been laid off yet. The first time he was laid off, his savings plus unemployment would have lasted about 6 months before his cashflow was an issue. Fortunately,  he found a job in about 3 months.

What happened after the first layoff is where the problem re-develops. What did he do? He continued spending after getting the next job, including a bunch of (borrowed) money to improve his home plus miscellaneous spending. He’s paying down his mortgage with additional principal. It’s been a number of years later and he still really hasn’t improved his financial situation. He is still vulnerable to a job loss.

There is lack of understanding or actually a lack of will on his part to address his situation and see how he can improve it. I don’t want to address the psychological issues, but the finance issues. Even though on paper his net worth is increasing, the steps he is taking has reduced his financial liquidity, which is the ability to generate cash easily without a reduction in asset value (selling for a loss, or below market price).

The damage a lack of liquidity can cause can been seen by what has happened over the past year in the economy.  Many companies are failing due to lower cash flows that aren’t covering debts, along with a broken credit market that has limited the ability to refinance the debt.

Using my friend as an example, these are the steps he could take to increase liquidity. Increasing liquidity would help to reduce his anxiety by increasing his ability to generate cash and increase cash reserves.

Sell The House

The psychological need to payoff the house is driving his anxiety over his job situation. This anxiety could be eliminated if he simply sold the house and rented an apartment or home. Instead of being on the hook for say, a 20 year mortgage, he would only be on the hook for an apartment lease of, say, 1 year. Also, the equity he would realize would be cash in his pocket. This decision would leave him in the most liquid position.

Refinance to a Longer Term

In my posts that gave you tips to refinance a mortgage, I talked about how to save money by reducing the total cost of your mortgage.  If you want to save the most money on a refinance, you would take a new loan with a shorter term. If you want to increase liquidity, you would want to do the opposite and take on a new loan with a longer term. This new loan would free up money each month because it will have the lowest payment. See Example #1 in the calculation post.

Stop Prepayment of Principal

When you pay extra money on your mortgage above the monthly payment, this reduces the total cost of the mortgage. However, this doesn’t affect the payment each month, it still remains the same. So this reduces your liquidity.

Don’t Fund Home Improvements

Paying out money to improve the home is less money available to pay the mortgage in the future. Even worse, he borrowed additional money to pay for the improvements which effectively increased his mortgage payment.

Spend Less, Save More

If he improved his cash flow by spending less, he would have more money available in the future to handle any income interruptions. He does not  plan spending or have a budget.

Summary

When looking at your own finances, you need to evaluate your own financial situation and make the appropriate adjustments to find your optimal comfort level.

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