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Recessions are inevitable, and given the current economic crisis being caused by COVID-19, another one seems imminent. Recession-proofing your finances means that you prepare for the worst so you can maintain stability through a downturn. This can be challenging amidst stay-at-home-orders and business closures, but if you’re still on stable financial ground now, these tips can help you get started.
The guiding principle: Savings good, debt bad
If you want to recession-proof your budget, focus on these two tasks:Less debt means less risk of default and more borrowing power in case you need it. More savings provide a bigger safety net if you have issues with your income and cash flow. Recessions bring higher unemployment, increased risk of layoffs, and lower tips and commissions. In the last recession, full-time employees even had their hours cut, often to 4-day work weeks. So, you need extra savings to pad your financial safety net.
Systematically minimize debt levels
Pay off credit card debt first
Start by eliminating high interest rate credit card debt first. Ideally, you want to maintain zero balances from month to month. So, everything you charge in a month gets paid off within that billing cycle. This not only minimizes interest charges but also helps protect your finances from risk during a recession.
If a recession hits, you don’t want excess credit card debt hanging around. It gives you less breathing room in your budget because you have more obligations to cover. If the worst happens and you lose your job, credit cards are often the first debts to slip into default.
That means if you believe a recession may hit later this year, you should take steps now to eliminate credit card debt. If you can’t pay off balances using a debt reduction plan in your budget, consider relief options:
Then focus on student loansfederal repayment plan. There are two plans (standard and graduated) that are designed to help you pay off student loan debt “quickly.” However, the term on these programs is ten years, so it’s not exactly fast. It’s just faster than other relief programs that have terms of up to 25 years.
If you really want fast student loan repayment and you have a good, steady income, the best option is student loan refinancing. You can use refinancing for federal and private student loans. This will give you the shortest term so you can really get out of student loan debt fast. However, just be aware that this converts federal loans to a private loan. You will no longer be eligible for federal student loan relief. If the recession hits and you lose your job, that could be a problem. So, consider this carefully before you take this step.
Need help weighing your options to get out of student loan debt? Talk to a student loan resolution specialist for a free evaluation to find the best solution for your needs.
Finally, be careful with risky auto loans
- If the economy takes a turn and you have a long-term auto loan (6 years or more), you may end up stuck with a loan you can’t afford and a car you can’t sell.
- If you have a variable rate loan, you also need to be concerned. Rates could increase suddenly just like they did on adjustable-rate mortgages at the start of the 2008 crisis.
If you’re in either of these situations with an auto loan, refinance now. Your best bet is to get the debt paid off in case the auto loan bubble really does burst.
Expand your financial safety net
In normal circumstances, experts say you should have 3-6 months of bills and budgeted expenses covered in savings. For example, let’s say your bills and necessary expenses cost $1,500 per month. A good emergency savings fund would be $4,500 to $9,000. This would allow you to maintain your budget without credit even if you lose your job for up to six months.
However, during a recession, 6 months may not be enough. During the Great Recession, people were unemployed for up to a year or more, on average. So, experts now say that if you anticipate a recession, you should save up to 1 year of expenses. Ideally, you want $18,000 in easily accessible savings accounts.
If that sounds excessive, just remember what this money is supposed to cover. The idea is that you can live on savings until you get a new job if you face a layoff. No massive run-up of credit card debt; no payday loans with ridiculous interest rates. You enjoy financial peace of mind even without full-time employment.
What are the best savings accounts for a recession?
The best savings account to have during a recession is a fixed-rate savings account that you open now. Over the past two years, the Federal Reserve has increased the federal funds rate about seven times. That’s the benchmark rate that financial institutions use to set base rates for loans and savings accounts. So, interest rates on loans are on the rise, but so are rates on savings accounts. You can find savings accounts right now that offer a 2% Annual Percent Yield (APY); that’s the interest rate on a savings tool.
If the economy takes a turn, the Federal Reserve will lower the federal funds rate. The idea is to encourage people to borrow to spur the economy. But that will also drop the APY you can find on savings tools. That’s why you want to get a fixed-rate savings account now. Get the account while rates are at their highest.
Also, be aware that if you have a variable-rate savings account, such as a Money Market Account, your growth will likely slow during the recession. The high rates you may be enjoying now won’t last if the economy takes are turn. That’s why fixed-rate accounts are your best option heading into a potentially weak economy.
3 key takeaways from the Great Recession
Borrowing against your equity is a risky proposition right before a recession
Arguably the most devastating part of the Great Recession was the real estate market collapse. It was certainly heart-breaking to watch people lose their 401(k) savings in the stock market crash, but most eventually recovered. But when the mortgage market collapsed, families lost their homes and in many cases, there was no going back.
A large part of the mortgage crisis resulted from excessive borrowing against equity. People took advantage of the boom years to take out second and even third mortgages. They used home equity loans and HELOCs without reserve or concern. But when the market collapsed and property values plummeted, those homeowners were severely upside-down. They owed far more than their homes were worth.
The hard lesson learned during the crisis was that borrowing against your home can be risky. Just because you have equity to use, it doesn’t mean that you should. If you worry about a recession, stick to a single traditional mortgage and don’t borrow against your home. In particular, avoid actions like taking out a home equity loan to pay off credit card debt. It’s just not worth the risk!
No job is 100% recession-proof, but some are recession-susceptible
There’s no guarantee that you can make it through a recession without hiccups in your employment. However, the Great Recession certainly showed the vulnerability of several professions:
- Anything in construction or real estate can be risky. Recessions don’t always come with a mortgage crisis, but a weak economy often leads to a housing market slowdown. If your career is dependent on an active health real estate market, you may want to consider supplementing your income.
- Hospitality is hard when everyone stays home. People in the service industry also suffered particularly hard during the Great Recession. As families felt the financial pinch, they stopped going out to eat and limited vacations. As a result, tips dried up and people’s customer base just wasn’t there.
- Startup businesses have a higher risk of closure. You don’t have any guarantee that a large company will weather the storm and avoid mass layoffs. On the other hand, working for a startup means you may be more at risk of the business closing entirely.
Approvals can be hard to come by during a recession
Lenders can choose to increase or relax their lending standards, as long as they follow federal and state regulations. During a recession, lenders face high rates of default from other borrowers. Basically, they can’t afford another bad loan that doesn’t get repaid.
This means it can be tough to get approved for financing. This is true both for personal loans and for any small business loans that you may need. If you want to get approved, you’ll need a great credit score and a low debt-to-income ratio. Only the most creditworthy can get approved.
That being said, recessions can often be a great time to refinance. The Federal Reserve typically lowers interest rates during a recession to stimulate the economy. If you have great credit and you followed the advice above, you can get really attractive rates on loans. Just make sure you have the means you cover the payments on whatever you borrow.
Published by Debt.com, LLC