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If you've ever been deep in debt, you know how hard it is to dig yourself out. But even if you manage to get your credit cards and other bad debt paid down, there's an important next step you need to take before you can declare yourself out of danger completely.

This week, I'm taking a look at how you can get your finances in order in just five days. Yesterday's article focused on the burden that credit cards and other debt can put on your budget. Once you're out of debt, you can start thinking about what you'll do with excess cash -- including the many ways you can invest it.

But before you decide you're going to become the next Warren Buffett with your stock portfolio, there's one other thing you ought to do first. It won't necessarily give you obvious rewards up front -- but in a bind, you'll realize just how essential it is to your financial health.

Handling emergencies
We've all been there: you think you've got all your expenses covered until your next paycheck ... until the furnace breaks. Or the car stops running. Or your kids need new soccer shoes. No matter how well you plan, there's always something that you won't specifically foresee.

Suddenly, you're in a bind and need money now. What are your options?

  • Take a credit card out of its hiding place and risk getting yourself right back into the debt trap again. With even some of the best credit cards from issuers like JPMorgan Chase (NYSE: JPM  ) and American Express (NYSE: AXP  ) charging anywhere from 12% to 20% interest, using plastic for your emergency just puts off handling the real question for another day.
  • Run off to a payday advance loan store like First Cash Financial (Nasdaq: FCFS  ) or EZCorp (Nasdaq: EZPW  ) to get a payday loan. Although some of these stocks were close to failure during the worst of the financial crisis, they've bounced back strongly since early last year. For customers, though, the high fees aren't exactly what you want to pay on a tight budget.
  • Go get money that you've put into an emergency savings account specifically for this sort of unexpected expense. Spend it, and set up a plan to replenish the account over the next several months.

Doesn't Door No. 3 look like the best option?

Worth the opportunity cost
Unfortunately, people aren't getting much of an incentive to set up an emergency account right now. Many banks pay next to nothing in interest. Even banks with above-average current rates -- ones like Capital One (NYSE: COF  ) , AIG (NYSE: AIG  ) , and Discover Financial Services (NYSE: DFS  ) -- won't pay you more than 1.5% on your money. Compare that to the 60%-plus gains the stock market has seen over the past year, and you can see why emergency accounts aren't that appetizing right now.

Moreover, setting aside huge blocks of money isn't all that easy in today's economy. Experts generally recommend saving three to six months in expenses, but if you're struggling to make ends meet, it'll take a long time setting aside $50 or $100 a month to reach that goal.

It's still worth it, though. Here's why:

  • The psychological hit to going back into debt can derail your financial recovery.
  • Even saving small amounts, you'll see yourself making progress slowly over time. You can point to that as a tangible result of all the work you're doing.
  • How much you need depends on your particular situation. Even before you reach your ultimate goal, you'll still be in a position to handle smaller emergencies -- ones that would have used to throw you back into debt's clutches.

Keep moving forward
As tempting as it can be during a bull market, starting to invest before you have enough emergency savings can end up being costly. Taking the time to cover the inevitable contingency of unexpected expenses will pay big dividends over the long run.

Stay tuned for the rest of the week as Dan continues his five-day financial fix series. Up tomorrow: It's time to invest.

Fool contributor Dan Caplinger curses the low rates he gets on his emergency savings, but he's still hanging onto it. He doesn't own shares of the companies mentioned in this article. American Express and Discover Financial Services are Motley Fool Inside Value recommendations. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is available 24 hours a day for your fix-it needs.

Read/Post Comments (2) | Recommend This Article (4)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 24, 2010, at 7:58 PM, georcole wrote:

    If you've already paid off your debt first, as you should, you have all of that money that was going towards your credit cards, car payments, student loans, mortgage, etc. to put away each month. It will likely take you about 3 or 4 months to save up an emergency fund. Yes, everything should be paid off first. I know some people are adamant that paying off your mortgage is not the wisest thing to do. In that case you still have that freed up $450 car payment, $300 total credit card payments, etc. to save. So saving 6 months emergency money doesn't take long, especially if you pay off your mortgage. Then your only expenses are utilities, food, taxes and insurance.

    So pay off all of your debt first and then you will have, for example: $2000 per month to save instead of $100. Your monthly expenses will be $1200 per month instead of $3200. You will save your emergency fund in 3-4 months ($1200*6 months =$7200/$2000 =3.6 months) instead of 16 years ($3200*6 months = $19200/$100 =192 months/12 months = 16 years).

  • Report this Comment On February 26, 2010, at 11:56 AM, PaydayLender wrote:

    Thank you for including payday loans as an option for emergency credit. Millions of customers across the country have used payday advance responsibly and appreciate having somewhere to turn when they need quick access to credit. The opinions of millions of hard-working payday advance customers have been lost in the debate over payday lending. Their voices are overshadowed by critics who have never actually used the service. Thank you for acknowledging real people's problems.

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