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Conceptual Questions
Q: What is liquidity, and why is it important in personal finance?
A: Liquidity refers to how quickly and easily an asset can be converted into cash without losing value. In personal finance, liquidity is important because it allows individuals to respond to unexpected expenses—such as medical bills, car repairs, or job loss—without needing to borrow money, incur penalties, or sell long-term investments at a loss.
Q: Describe the difference between a checking account and a savings account in terms of liquidity and return.
A: A checking account is highly liquid, meaning money can be accessed at any time via debit card, ATM, or online transfer. However, it typically earns little or no interest. A savings account offers moderate liquidity—funds are accessible but may have withdrawal limits—and typically pays more interest than a checking account.
Q: What does APY stand for, and how is it different from a nominal interest rate?
A: APY stands for Annual Percentage Yield. It reflects the total return an account earns in one year, including the effect of compounding interest. In contrast, the nominal interest rate is the stated (non-compounded) rate. APY is a more accurate measure of how much money you actually earn.
Q: Why is it important to consider after-tax yield when comparing financial products?
A: Because interest earnings are often taxable, the actual income you keep may be less than the advertised rate. After-tax yield reflects the real return on your investment after federal and possibly state taxes, helping you make better comparisons between taxable and tax-advantaged accounts.
Q: List and briefly explain three types of financial institutions that offer liquid asset accounts.
A:
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- Commercial banks – Offer checking and savings accounts, CDs, and online banking services.
- Credit unions – Member-owned institutions offering similar services to banks, often with lower fees and better rates.
- Online banks – Operate without physical branches, often offering higher APYs and fewer fees due to lower overhead costs.
Q: What is the Emergency Fund Ratio, and what does it measure?
A: The Emergency Fund Ratio = Liquid Assets ÷ Monthly Essential Expenses. It measures how many months a person can cover basic expenses without income. It helps assess short-term financial resilience.
Scenario-Based Questions
Q: Jordan earns $2,800 a month after taxes and currently has $3,500 in a checking account. He keeps no other savings.
– Calculate his Emergency Fund Ratio.
A: $3,500 ÷ $2,800 = 1.25.
Jordan has enough liquid savings to cover 1.25 months of expenses.
– Is he financially prepared for a job loss? Why or why not?
A: No. Financial experts recommend having at least 3–6 months of expenses saved. Jordan’s current emergency fund would not be sufficient for a prolonged job loss.
– What steps could Jordan take to improve his liquidity management?
A: Jordan could set up automatic transfers to a high-yield savings account and reduce discretionary spending to increase his emergency fund gradually.
Q: Amira split her liquid assets across three products: $2,000 in a checking account, $2,500 in a savings account earning 3.50% APY, and $3,000 in a 12-month CD earning 5.00% interest.
– Which of Amira’s assets are fully liquid, and which are not?
A: The $2,000 in checking and $2,500 in savings are fully liquid. The $3,000 in the CD is not, as it is locked for 12 months and may incur penalties if accessed early.
– If she suddenly needs $4,000 for a medical emergency, what are her best options?
A: She should withdraw from checking and savings first ($4,500 total) to avoid early withdrawal penalties from the CD.
– What penalties or risks might she face if she withdraws from her CD early?
A: She may lose several months’ worth of interest (often 3–6 months) and possibly pay an early withdrawal fee, reducing her total earnings.
Q: Leo uses a digital app that automatically rounds up his purchases and transfers the difference to a savings account. Last month, he overdrafted his account three times due to these automatic transfers.
– What is the potential downside of automated digital tools like this?
A: Automation can cause overdrafts or missed payments if not monitored. Apps can act on preset rules without adjusting to low balances or upcoming bills.
– How could Leo adjust his system to keep using automation without overdrafting?
A: He could disable auto-transfers when his balance falls below a threshold or link a backup account. He should also monitor transactions weekly.
– What role does liquidity play in avoiding these kinds of errors?
A: Liquidity ensures funds are available when needed. If Leo had maintained more cash in his account, overdrafts likely wouldn’t have occurred.
Problem Solving
Q: You have $8,000 in liquid savings and monthly essential expenses of $2,000. Calculate your Emergency Fund Ratio. What would be a safe target ratio, and how much more would you need to save to reach it?
A:
Emergency Fund Ratio = $8,000 ÷ $2,000 = 4.0
A safe target is 6 months. To reach it:
6 × $2,000 = $12,000 target
$12,000 – $8,000 = $4,000 more needed
Q: Maria has $3,200 in a money market account and $1,000 in a CD. She owes $1,900 in short-term bills this month. Calculate her Current Ratio and Quick Ratio.
A:
Current Ratio = ($3,200 + $1,000) ÷ $1,900 = $4,200 ÷ $1,900 ≈ 2.21
Quick Ratio = $3,200 ÷ $1,900 ≈ 1.68
Maria is in a strong liquidity position, especially since she can cover her obligations without needing the CD.
Q: Compare the after-tax yield of the following two options. Assume a 24% tax rate:
– A savings account offering 4.00% APY
– A money market mutual fund offering 5.25% APY
Which one offers the better real return after taxes?
A:
Savings: 4.00% × (1 – 0.24) = 3.04%
MMMF: 5.25% × (1 – 0.24) = 3.99%
The money market mutual fund offers the better after-tax return.
Q: Alan invests $5,000 in a CD that earns 5.5% interest annually. He withdraws the money after 9 months, paying a 3-month interest penalty. How much interest does he earn after the penalty?
A:
Annual interest: 5,000 × 0.055 = $275
Interest for 9 months: $275 × (9 ÷ 12) = $206.25
Penalty: $275 × (3 ÷ 12) = $68.75
Net interest earned: $206.25 – $68.75 = $137.50
Q: Create a liquidity plan for someone who earns $3,500 a month, wants to build a 4-month emergency fund, and is deciding how to split funds between a savings account and a CD.
A:
Target emergency fund: 4 × $3,500 = $14,000
Suggestion:
– Save $10,000 in a high-yield savings account (accessible for emergencies)
– Place $4,000 in a 6-month CD (to earn higher interest without locking up all funds)
This balances accessibility with earnings while reaching the liquidity goal.
Q: Using what you’ve learned, write a one-paragraph recommendation for a friend who wants to keep $10,000 safe but still earn interest—without risking access in an emergency.
A:
I recommend you keep $7,000 in a high-yield savings account so you have easy access to cash for emergencies. You can place the remaining $3,000 in a short-term CD (3 to 6 months) to earn a higher interest rate. This way, most of your money remains liquid, but you also take advantage of better returns without putting your financial flexibility at risk.
