3 Ways to Avoid Financial Disaster | The Motley Fool (2024)

There's a clear difference between a financial setback and a financial disaster.

Financial setbacks happen. At some point, you might lose your job, your car could need some unexpected and costly repairs, or you could get sick and face mounting medical bills, just to name a few possibilities. And if you don't take steps to protect yourself, these setbacks can quickly turn into full-scale financial disasters.

With that in mind, the three most important things you can do to increase your financial health and set yourself up for whatever obstacles life throws your way are:

• Make your emergency fund a priority.
• Keep your credit score high.
• Use debt sparingly.

Obviously, there's a bit more to each of these, so let's take a closer look:

1. Prioritize your emergency fund

Roughly half of Americans couldn't pay for a $500 unexpected expense without selling something or borrowing the money, according to Federal Reserve data. The ability to pay for unexpected expenses can be the difference between a financial inconvenience and getting trapped in a never-ending cycle of high-interest credit card debt.

Financial planners generally recommend that you should aim to have six months' worth of expenses set aside in a readily accessible place like a savings account. And while this is certainly a great goal, it can be an intimidating amount of money to try to set aside. For example, if your monthly expenses including all of your bills and necessities add up to $4,000, this implies an emergency fund of $24,000. That can take years for even good savers to accumulate.

However, the most important thing to keep in mind is that you don't need to get there right away, and something is certainly better than nothing. After all, having just $1,000 set aside for emergencies would put you in better financial shape than the majority of Americans.

The best strategy is to make saving automatic. Determine an amount you could comfortably afford to save from each paycheck and set up an automatic transfer to your bank account that you use for your emergency fund. You'll be surprised how quickly it builds up.

2. Keep your credit score high

One financial principle is that good credit equals financial flexibility. A top-tier credit score gives you the ability to borrow money at a minimal cost. For example, there are many credit card offers with 0% introductory APRs for a year or more, but you'll need strong credit to take advantage. And while we certainly don't want to take on unnecessary debt, having the flexibility to borrow as needed can help avoid financial disasters.

The FICO credit scoring formula is a closely guarded secret, but you can achieve a great credit score by following common-sense credit behaviors. Pay all of your bills on time, keep your revolving (credit card) debts low, and don't apply for credit more than you need to. And if you want to maximize your credit score, you can learn the framework of the FICO score and use it to your advantage to boost your score even higher.

3. Use debt sparingly

To be fair, the word "debt" covers a broad spectrum. There are some good forms of debt (like mortgages), some decent forms of debt (like auto loans and student loans), and then there are some dangerous forms of debt (like credit cards).

A good way to boost your financial health is to keep your use of dangerous debt to a minimum and think twice before taking on one of the decent forms of debt. Avoid carrying credit card balances at high interest rates. If you need to take out an auto loan, don't max out your budget.

By using debt only when you need it and not stretching your budget just because you can borrow money, you'll be in strong financial shape if something goes wrong.

Plan for the unexpected

The general idea here is that you should plan for the unexpected during the good times. An emergency fund lets you pay for many unforeseen costs without having to use your credit cards or take on other forms of debt. Strong credit gives you the ability to borrow if you don't have the available cash to pay for a larger expense. And by minimizing debt, you not only keep your monthly payment obligations low, but you also keep your borrowing capacity available for when you really need it.