Do This Before You Invest a Cent

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There's nothing sexy about putting money in a savings account. But especially given today's tough job market and the uncertain health of the global economy, it's more important than ever to have financial resources behind you in case the worst happens.

Unfortunately, having emergency funds available is a luxury that many American households don't have right now. According to a report from the University of Michigan, almost a quarter of all families haven't saved any money at all, while a fifth have more debt from sources including student loans, medical bills, and credit cards than they have in savings.

It's not too hard to understand why so many people don't have the financial safety net they need. Throughout the housing boom, freely available home equity loans and lines of credit made it easy to tap real estate gains to finance all sorts of spending. Huge mortgage financers Citigroup ( C ) and JPMorgan Chase ( JPM ) as well as smaller banks around the country had every incentive to close cash-out refinanced mortgages to pocket servicing fees. At the same time, the better job market kept wages up and gave most people a reasonable standard of living.

Now, though, extended periods of unemployment have forced many people not just to use whatever emergency funds they had but also to tap longer-term investments like retirement accounts. Millions of homeowners are underwater on their mortgages, and even after a $25 billion settlement related to mortgages serviced by big banks Wells Fargo ( WFC ) and Bank of America ( BAC ) as well as Citi and Chase, borrowers are finding it hard to refinance even if they're eligible for government help or have equity in their homes. Moreover, even with relatively low interest rates on many kinds of debt, the sheer amount of student loans and other outstanding balances can make it very difficult to get back on your feet even once you do find a job.

The news from the report isn't all bad. Nearly half of the families surveyed say they don't have any unsecured debt at all. Moreover, almost 15% have at least $50,000 set aside in readily available savings.

But even that statistic could mean problems down the road. For some households, big cash balances represent scared investors who've moved their investments out of risky assets like stocks and put their money in the bank. With most banks paying less than 1% on savings accounts -- in many case, far less -- savers aren't even getting enough income to make up for inflation and taxes, let alone give them any true return on their money.

The standard rule of thumb says that setting aside enough money to get you through three to six months should handle the worst of emergencies. That figure is based on an assumption, though: that you'll be able to get a new job and restore most of your previous income within that time frame.

For some workers, that's a realistic assumption even in a bad economy. High-demand jobs like nursing have constant turnover and extensive job openings, making it easy to switch. But for many workers, it can be very difficult to find new employment after a layoff, suggesting that having more savings set aside isn't a bad idea.

Emergency funds don't all have to be stuck in cash. Many people find that having readily available credit sources to tap works just as well. The trap, though, is that if you use debt sources as part of an emergency fund, a big emergency can leave you stuck with that debt longer than you might expect. It's therefore very important to use the lowest-cost debt you can find -- avoiding high-rate credit cards in favor of lower rates on home equity credit lines, for instance.

Given how exciting investing is, it's hard to wait until you have an emergency fund set up. But if the worst does happen, then you'll be glad you did.

Once you have your emergency fund set up, then you'll want to turn your attention to making smart investments. The Motley Fool's special report on long-term investing can help you figure out where to find the best stock prospects for the long haul, with three names submitted for your consideration. Let me invite you to click here and get your free copy right now.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter here .

Fool contributor Dan Caplinger is never convinced he's prepared for everything. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of all four banks mentioned in this article and has created a covered strangle position in Wells Fargo. Motley Fool newsletter services have recommended buying shares of Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. You can bank on The Fool's disclosure policy.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Personal Finance , Basics , Credit and Debt

Referenced Stocks: BAC , C , JPM , WFC

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