Preparing for a Possible Recession
A recession represents a decline in economic activity and often leads to high unemployment. Recessions are a natural part of the business cycle, but they can also have a detrimental effect on your finances. Recessions come and go, but they are historically difficult to predict. Learn how to prepare for a possible recession by adjusting your personal finances accordingly.
What Happens During a Recession?
A recession is defined as a significant decline in economic activity that affects the entire economy and lasts several months or more. More specifically, it is a decline in gross domestic product (GDP) in two consecutive quarters. Although in the U.S., a recession must be officially declared by the Business Cycle Dating Committee of the National Bureau of Economic Research.
The economy is cyclical and goes through peaks and troughs throughout the business cycle. Once the economy reaches its peak, it will start to contract until it eventually bottoms out. The economy will then start growing again to repeat the process.
Recessions are inevitable, but they aren’t always predictable. Unforeseen events like a global pandemic, war and natural disasters can trigger a recession. Economists may look to other indicators like consumer confidence, the unemployment rate and stock market earnings to get a sense if a recession is on the horizon.
When a recession strikes, businesses and consumers reduce spending, leading to higher unemployment and less economic activity. The investors may experience a bear market (when the market experiences prolonged price declines of 20% or more from recent highs) or increased volatility across the stock market.
During a recession, the Federal Reserve and government may take actions to lessen the adverse effects. They may introduce new monetary policy or stimulus bills to help lessen the impact of the recession on people’s finances.
A recession can last anywhere from several months to several years. Once the recession ends, the economy will usually regain all the jobs that were lost during the downturn. The stock market will also regain its value, but the recovery may take years.
How to Prepare for a Possible Recession
A recession can hurt your finances. People may lose their jobs or see stricter borrowing guidelines for new credit. Learn how to prepare your finances for a sudden economic downturn to help recession-proof your finances and stay on track to meet your goals.
Set a Budget
If you don’t track your spending, now is the time to get started. Create a budget to get a sense of how much money you have coming in versus how much you’re spending. During recessions, it’s not uncommon to see job loss, reduced hours, or less work for the self-employed.
If your income varies every month, you might have to rein in your spending. Get a sense of how much you need to pay for the essentials every month.
You should only allocate around 50% of your net income to essential expenses like housing, food, utilities, and transportation. Another 20% should go into your savings account or towards paying off debt. The other 30% is yours to spend however you please. This is what’s known as the 50/30/20 budget.
You can adjust these percentages as your financial situation changes. If you think a recession is on the horizon, take a look at your budget. See what items you can cut back on and what needs to be a priority.
Create an Emergency Fund
Building an emergency fund is one of the most important financial goals to have, especially if the future is uncertain. Normally, experts recommend having three to six months of expenses saved but saving more (six to 12 months) can give you more flexibility in the event of an emergency.
If you already have an emergency fund, consider adding more to your fund than you normally would if a recession seems likely. Fewer companies will be hiring during a recession, and it may take you more than three months to land a new job.
If you are living paycheck to paycheck and having trouble saving money for an emergency, now is the time to build your own safety net. Make a list of charitable organizations, friends and family that might be able to help you in an emergency. For example, you might be able to move in with a loved one if you can’t afford to pay rent.
You can also reach out to rental assistance programs, apply for food stamps and other government programs that can help you stay afloat when times get tough.
Supplement Your Income
Look for ways to supplement your income if things get tight. Picking up a second job, starting a side hustle or taking in a roommate can help you earn more. You can even sell old clothes and other goods in a pinch.
If you don’t have time for another job or side hustle, you can look into developing new skills that can help you earn more at your current job or make it easier to find a new one.
Improve Your Credit Score
Credit becomes scarce during a recession. Financial lenders typically increase their lending standards when there is less money flowing around the economy. This will make it harder to get approved for a mortgage, auto or personal loan.
Do your best to boost your credit score by paying your bills on time and using your credit wisely. Monitor your credit score regularly to see how it is changing over time. Contact one of the three credit reporting agencies to fix any issues that may impact your score.
Having a strong credit score will help you access funds or buy items on credit if your hours are cut at work.
Avoid Panic Selling
The stock market will take a hit when the economy starts to contract. You might be tempted to sell off your stocks as prices continue to fall, but markets tend to rebound and see strong growth in the years following a recession. Getting out of the stock market can mean missing out on the opportunity to buy stocks when they are on sale.
Instead of trying to wait for the bottom and time the market, many experts recommend dollar-cost averaging, or systematically investing small amounts on a regular basis. This strategy is often used by long-term investors in retirement accounts to consistently build their wealth over time.
If you don’t have a long time horizon or are approaching retirement, work with a qualified professional to create a financial plan to help protect your nest egg and retirement funds.
Keeping track of all your current outstanding debts and making your payments on time is extremely important. If you fall behind on your regular payments, the interest will be compounded, making it that much harder to get out of debt.
Paying off high-interest credit card debt can be a challenge during a recession. Use debt payment strategies like the avalanche method which focuses on paying down the debt with the highest interest rate as quickly as possible while still paying the minimum amount owed on your other statements.
Consider applying for a low-interest personal loan or line of credit to consolidate your debt before credit availability tightens. The loan will replace your other outstanding debts, leaving you with one regular monthly payment.
You may also have trouble paying your student loans during this time. Consider applying for an income-driven repayment plan or asking for a pause on your payments if your income level falls. You might also want to sign up for a new repayment plan when interest rates are low to speed up the repayment process.
With preparation and planning, you can lessen the effects of a recession on your finances. Know what resources are available to help you and maintain good financial habits to protect yourself through times of financial uncertainty.