Liquid Reserves: What They Are and How Much You Need

Liquid reserves are assets that can be converted into cash on short notice with little to no loss of value. These funds serve a dual purpose: they are a measure of financial health that lenders review when you apply for a major loan, and they provide a personal safety net to handle unexpected expenses.

Components of Liquid Reserves

A liquid asset’s defining characteristic is how easily and quickly it can become spendable cash. Some assets are immediately available, while others require a sale or transfer that can affect their final value. For financial assessments like a mortgage application, assets are categorized based on this liquidity. The most accessible assets form the core of your reserves and are accepted at their full value.

Cash, checking accounts, savings accounts, money market accounts, and certificates of deposit (CDs) are the most common liquid reserves. These assets have a stable value and can be accessed almost instantly.

Other assets, while convertible to cash, are less certain in value. Investments like stocks, bonds, and mutual funds are considered liquid reserves, but lenders may not accept them at their full market value. A lender might, for example, only count 70% of the value of a stock portfolio to account for potential market fluctuations and transaction costs.

Certain assets are not counted as liquid reserves because they cannot be quickly converted to cash, such as real estate and vehicles. Retirement accounts like a 401(k) or an IRA are also excluded if the owner is under age 59.5. Early withdrawals incur a 10% penalty from the IRS on top of regular income taxes, which reduces their accessible value.

Calculating Required Reserves for Mortgages

When you apply for a home loan, lenders require you to have a certain amount of liquid reserves remaining after you pay your down payment and closing costs. This demonstrates your ability to handle mortgage payments if you experience a temporary loss of income.

To determine the required amount, lenders use your future monthly housing payment, often abbreviated as PITI. PITI includes:

• Principal
• Interest
• Taxes
• Insurance

If applicable, this calculation will also include homeowners association (HOA) fees.

The reserve requirement is expressed as a number of months of PITI. For example, if a lender requires six months of reserves and your monthly PITI payment is $2,500, you would need to show proof of $15,000 in liquid assets available after the loan closes. The number of months can vary from two to six for a primary residence and may be higher for second homes or investment properties.

To verify these funds, you must provide recent statements from all relevant accounts, such as two to three months of bank statements for checking and savings. You will also need to provide brokerage statements for any investment accounts being used. Lenders review these documents to see that the funds are seasoned, meaning they have been in your account for a period and were not just deposited to qualify for the loan.

Establishing a Personal Emergency Fund

Separate from any lender requirement, a personal emergency fund is a liquid reserve you create for your own financial security. This fund is designed to cover unforeseen life events, such as a job loss, a medical issue, or an urgent home repair. It provides a financial buffer that prevents you from having to take on high-interest debt or sell long-term investments during a crisis.

The guideline for an emergency fund is to save three to six months’ worth of essential living expenses. To determine your target amount, add up all necessary monthly costs, which include:

• Housing
• Utilities
• Food
• Transportation
• Insurance premiums
• Minimum debt payments

Discretionary spending on items like entertainment or dining out is not included.

Deciding whether to save closer to three or six months of expenses depends on your personal circumstances. An individual with a stable job and a second household income might be comfortable at the lower end of the range. A freelancer with fluctuating income, a single-income household, or someone with dependents should aim for the higher end, potentially even more than six months.

The purpose of this fund dictates that it must be held in a highly liquid and safe account. A high-yield savings account is a common choice because it keeps the money accessible while earning a modest amount of interest. It is best to separate these funds from your regular checking account to reduce the temptation to spend them on non-emergencies.