If a Recession is on the Horizon, What Can I Do About My Debt?
Recessions cause a slowdown in economic activity, and can lead to job losses. To be recession-proof, it’s helpful to strengthen your finances ahead of time.
July 5, 2022
This article is provided for informational purposes only and should not be construed as legal or investment advice. Always consult with a professional financial or investment adviser before making investment decisions.
The economy tends to run in cycles. Economic activity expands for a while, then retracts — in what is known as a “recession.”
During a recession, economic activity slows. This can lead to layoffs, reduced consumer confidence, stock market declines and other negative financial outcomes.
While you can’t prevent a recession, you can take steps to strengthen your financial standing ahead of time. Here’s what you need to know.
What is a recession?
A recession is when economic activity slows down, usually for at least six months. Basically, it’s when the economy shrinks.
The main measurement used to determine a recession is called gross domestic product, or GDP. This figure measures the total value of all goods and services produced in a country in a given period.
If GDP is rising, that means the economy is expanding. If GDP is falling, that means that the economy is shrinking (a recession); most economists measure economic activity (trade and industrial activity) for at least two consecutive quarters (six months).
Recessions are a normal part of the economic cycle. They tend to happen once per decade or so. On average, a recession lasts around 15 months.
Many believe that we are on the brink of a recession in 2022, although this remains to be seen.
How could a recession impact my finances?
Everyone will be affected differently, depending on their financial standing, career security, etc. However, here are some of the broad ways that a recession could affect you financially:
Potential job loss
During recessions, companies often lay off staff to reduce payroll expenses.
Asset price declines
If you have investments, they are likely to decline in value during a recession.
Interest rates may change during a recession. If you have debt, this could mean you might end up paying more in interest.
Sometimes, recessions come during times of increased inflation. In this case, your everyday expenses might increase.
Recessions can also alter the overall economy, which may influence your day-to-day life. For instance, your favorite restaurant may close down or your friend may lose her job.
How can you prepare for a recession?
Nobody can prevent a recession from happening but we can take steps to protect our finances from their effects. Here’s how.
Pay down debt
Paying off debt can strengthen your finances. It can help improve your credit, reduce your monthly expenses and bolster your overall financial well-being.
This is particularly true of high-interest debt, such as credit cards. Credit card debt can be extremely costly; the typical APR is over 20%.
Plus, interest rates on credit cards often rise during recessions. So you could end up having to pay even more toward your existing debt.
If you have credit card debt, check out Tally† — an app that helps qualifying Americans consolidate their credit card debt and pay less in interest. Learn how Tally works here.
For more tips on how to pay off debt, check out the Tally blog.
It’s important to balance debt with other financial priorities. You definitely need an emergency fund — particularly if a recession is on the horizon — so you don’t want to burn up all your cash paying off debt.
Bulk up your emergency fund
An emergency fund is a chunk of money set aside for unexpected expenses or loss of income. Everyone should have one, but the importance is magnified during a recession.
As the economy contracts, employers are more likely to announce layoffs. Even if your job seems secure, it’s always wise to be prepared.
Experts recommend setting enough aside to cover three to six months of living expenses. So if your expenses are $4,000 per month, you should have between $12,000 and $24,000 in your emergency fund.
If that seems impossible, know that any amount of savings is better than nothing. If you can take steps now to increase your emergency savings, you’ll be better prepared for uncertain financial times ahead.
You should keep your emergency fund in liquid savings, like a high-yield savings account. That way, you’ll earn a bit of interest and your savings won’t be at risk during stock market fluctuations.
Asset prices are often volatile during recessions. In most cases, a recession means that the stock market and other asset classes will decline in value — at least temporarily.
Now is a good time to take a look at your investments and make sure you are properly diversified. Diversification means having money invested in a wide variety of assets so that a decline in one asset won’t derail your whole portfolio. While no one type of investment is recession-proof, diversification can help mitigate risk.
You’ll also want to double-check your investment philosophy and your risk tolerance. If you have only invested in stocks, are you prepared for a significant market decline? If you think a drop of 20% or 30% would cause you to panic sell, it might be wise to decrease your risk by adding some bonds or other lower-risk assets.
Examine your budget
Check your budget and reevaluate. Does your spending align with your values and financial goals?
Now is also a good time to think about what expenses you might cut should a recession strike. For example, look at your optional spending categories — restaurants, shopping, etc. — and see where you might be able to cut back and start saving some money.
Make a plan
Finally, make a plan for the worst-case scenario. What happens if you lose your job? Or your partner loses theirs?
Nobody wants to think about these situations, but if you do, you’ll be more prepared for whatever comes your way.
Nobody knows for sure whether a recession is coming or not — but it always helps to recession-proof your debt in some way. You can take steps now to strengthen your financial standing, like paying off debt, diversifying your investments and bolstering your emergency fund.
†To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. Based on your credit history, the APR (which is the same as your interest rate) will be between 7.90% - 29.99% per year. The APR will vary with the market based on the Prime Rate. Annual fees range from $0 - $300.