5 Steps to Perfect Financial Health

By Wendy Connick Markets Fool.com

We all know the basic steps we can take to improve our physical health: eat nutritious foods, exercise, get plenty of sleep, and so on. But how do you get in tip-top financial health? Beyond "save more and spend less," many of us don't quite know. So here's one plan you can follow to whip your finances into Olympic-quality shape.

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Step one: Get rid of your bad debt

Carrying around a lot of debt is like going through your day wearing a backpack full of rocks. It slows down all your progress and holds you back from accomplishing things that would otherwise be easy. In fact, debt can even put you in a state of negative gain. For example, let's say you have $1,000 tucked away in investments that are earning you a 10% return every year. That's a great return, but if you also have $1,000 of credit card debt with an APR of 15%, you're still losing money overall. And 15% interest is actually quite low compared to typical credit card rates. Clear out all that high-interest debt, and you'll give your net worth a chance to really grow.

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Step two: Save for emergencies

Once you've gotten rid of all that nasty bad debt, the next step is to take out a sort of insurance to keep yourself from getting swamped by bad debt in the future. An emergency fund gives you a resource other than credit cards that you can turn to in times of financial need. How much should you set aside in your emergency fund? Three months' worth of expenses is a bare minimum; six months' to a year's worth is a better goal. This money should be stashed in a highly liquid savings vehicle -- i.e., something you can tap at a moment's notice. A bank savings account is one option, but an Internet bank money market account will pay much higher interest and still be quite easy to tap when a financial crisis hits.

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Step three: Save for retirement

Saving for emergencies is vital, but you don't want to have too much money in your emergency savings fund, because you won't get high returns on that money. In the current interest rate environment, you'll be lucky to get more than 1% interest on a savings account, which is a far lower return than you can expect on stock investments held over the long haul. So once you're free of high-interest debt and you have a rainy-day fund, start funneling your savings into an investment account. Tucking the money into a tax-advantaged retirement account, such as a 401(k) or IRA, will enhance your returns, because that money can grow tax-free.

Both traditional and Roth retirement accounts have their place in nearly every worker's retirement planning. Traditional tax-deferred retirement accounts give you a substantial tax benefit during the contribution phase but make you pay taxes on your distributions, while Roth accounts work the other way around. You can learn more about traditional and Roth accounts here.

Step four: Pay off your good debt

In step one, you took care of the bad debt that was killing your financial future. Now that you've addressed the highest-priority financial health items, it's time to start cutting back your "good" debt. Good debt includes student loans, mortgages, and possibly auto loans. These debts typically charge low interest rates, so they're not terribly damaging to your finances, but the monthly payments do add significantly to your expenses. Just think about how much more money you'd have to spend every month if you had no house payment or car payment to worry about. Mortgages are typically the most daunting of good debts to pay off, as they typically amount to hundreds of thousands of dollars. However, once you pay your mortgage off, you will free yourself of a big financial burden and free up a lot of money that can invest in your future.

Step 5: Celebrate!

By this time, you've gotten yourself completely out of debt, you've built up an emergency savings account, and you're regularly contributing to a retirement savings account. Your finances are now in phenomenally good shape, and you have a bright financial future ahead of you. Take some of that money you once spent on debt payments and use it to enjoy yourself -- you've earned it!

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