Asset liquidity is one of those financial terms that sounds a lot more complicated than it actually is. It’s also a concept that is very important to understand if you’re in the market for a mortgage.
If you’ve applied for a home loan in the past, you’re probably aware that lenders have asset requirements that aspiring homeowners must meet in order to get a mortgage. This is to ensure that people will still be able to pay their principal, interest, taxes and insurance (PITI) in case of financial emergency.
What Is Asset Liquidity?
As part of these asset requirements, lenders also want to make sure that enough of your assets are “liquid.” So what does that mean?
Assets are items that you own that have value. Among other things, assets can include savings accounts, stocks, jewelry and other property. When an asset is “liquid,” it has cash value, or can be easily converted to cash.
As they say, cash is king. Everyone likes cash because everyone knows how much it’s worth, and cash is easily transferable. Ever tried to buy coffee with silver ingots? I wouldn’t try it.
Why Is Asset Liquidity Important?
Liquidity is important in cases of financial emergency. Imagine that you own a parcel of land that is quite valuable, along with some rare Picasso paintings that your dear, old Aunt Beverly left you in her will. Aside from that, you have a decent job, however your monthly expenses are around the same as what you’re making, so you can’t really save that much. But when you look at your balance sheet, you’re pretty well off, or at least “on paper.”
Now say an unfortunate financial emergency befalls you, like an unexpected auto repair or medical bill. You still have to pay your mortgage, but you can’t because you don’t have anything extra saved up, and you don’t want to borrow the money from someone else.
Now you could sell that parcel of land or one of your pieces of art, but that takes time. Appraisals must be made, buyers must be courted. These things take time – time you don’t have – and your mortgage is due before you would be able to liquidate these assets.
Those assets don’t help you in a financial emergency because, relatively speaking, they’re not liquid enough to do you any good when you need them. When you’re thirsty, you need a drink of water. You don’t necessarily need a machine that slowly distills water droplets from the air and fills a glass of water several days later. It’s cool, but it doesn’t help you when you’re thirsty.
Examples of Liquid Assets:
- Deposit account funds (checking and savings)
- Certificates of Deposit (CDs)
- Mutual funds
Examples of Non-Liquid Assets:
- Real estate property
- Commodities (gold, oil, pig bellies)
Most lenders will suggest that it’s always a good idea to have 6 months’ worth of liquid assets available to pay your PITI in case of an unforeseen issue. That way, the lender knows you’ll be able to absorb a financial hardship if the unexpected happens.
If you’re in the market for a mortgage and have questions, check out the Mortgage Basics section of the Zing Blog!