6 Ways to Prepare Your Finances for a Recession
, by Rob Kaufman
Just a couple of months ago, the economy was strong and the stock market was at record highs. With the spread of COVID-19 and uncertainty about the economy, now is a good time to prepare for the possibility of the economy tipping into recession.
A recession means two or more quarters in a row of negative GDP growth. (GDP is the total value of everything the country produces.) This negative growth tends to show itself with decreases in income, growing unemployment, and less consumer spending.
The average length of a recession is eleven months. Some downturns can be shorter, but some can also be longer. The Great Recession lasted for over nineteen months from December 2007 to June 2009.1 Some are mild, and some are severe. No one knows how much impact COVID-19 will have on the economy or how long it will last, but it is a good idea to be prepared for a recession - short or long, mild or severe. Here's how:
- Build up your emergency fund
An emergency fund should hold about three to six months of living expenses. When there's talk of a potential recession, it's a good idea to increase your fund to a year of expenses. From a Bankrate survey, 19% of Americans incurred substantial debt, and 15% said that they or their partner lost their job during the Great Recession.2 Having an emergency fund can help during these situations so that there won't be a need to borrow money in case something unexpected happens.
The first step is to look at your income and spending, most notably your fixed costs. Add up those bills and multiply that amount by the number of months you want to have available in your fund. Once you know the amount of money you'll need each month, contribute as much as you can each week into a savings account. Start to automate your savings so that you're basically paying your future self.
- Figure out where your money is going
Like #1 above, analyze your spending. Look at the categories you are spending your money on besides paying for bills. These spending categories could include food, transportation, healthcare, entertainment, or education. It is empowering and beneficial to know where your money is going.
As you find out what categories you are spending on, it's the best time also to set a budget. Many people use the 50/30/20 method: 50% of income goes to necessary fixed costs, 30% goes to what you want, and 20% goes to savings. When you are concerned that a recession is coming, these numbers should change to percentages that will help you build an emergency fund. It's different for everyone, so there are no set amounts. Only you can determine how much you'll need each month.
- Get your credit ready for a recession
What? Why should you concern yourself with your FICO® Scores when preparing for a recession? Well, if you need to take out a loan or if you're looking to purchase a home during a recession (when home prices typically drop), lenders usually loan money to the most reliable borrowers.
Research shows that people who are more resilient to an economic downturn, on average:
Have a moderate mix of credit types
Have lower credit card balances
Have a longer credit history
Have fewer active accounts
Are not actively searching for credit
Have a history of paying their bills on time
Keep your eye on your credit reports and check your FICO Score frequently. Make sure your reports don't contain errors, that there's no fraud and that your information is all up to date.
Check out Protecting Your Credit During the Coronavirus Outbreak for more information and a checklist for staying on top of your credit.
- Pay down your debt
The last thing you want while you're out of work or having trouble paying bills is your debt ballooning. Start paying down your high-interest debt now. Paying down your debt may also free up money that you can contribute to your emergency fund instead.
These are two methods you can use to help pay down debt:
If you want to minimize the total interest you'll pay, the avalanche method might be your best bet. Once you know the interest rate for each balance, make the minimum payment on all balances but put any extra money towards the balance with the highest interest. Once that balance is eliminated, start paying more money on the balance with the next highest interest until all your debt has disappeared.
If you want your balances to disappear completely, the snowball method may be best for you. Each month, pay the minimum on every card balance while at the same time putting your extra cash toward the lowest balance. Once that is paid off, use the money you would've used for that balance and pay the next highest balance.
- Keep building up your investments
While stock market declines are normal during a recession, it's important to continue contributing to your investment accounts and possibly not sell off your stock. Why?
Lower prices for stocks, mutual funds, ETFs, etc. (the assets within your accounts) mean you'll be buying your investments at "sale prices." As an investor, you should think about the long-term effects of your decisions. Recessions won't last forever, so the stock market will eventually recover as it did after the Great Recession. You can benefit from the rebound if you continue to contribute to your investment accounts during economic downturns.
- Invest in your career
Just as important as investing in the stock market is investing in yourself. Keep an eye on how your employer, industry and your job might fair in a recession. Know what industries might grow or remain stable during an economic downturn and the recovery that follows.
Using this information, you can determine if any of these industries might be a good fit for you - and if you'd enjoy working within them. Then get the education or training you need to make the change should you need (or want) to. Investing in yourself is a great way to ensure that whether or not there's a recession, you'll always be prepared for change.
An important note to remember about recessions is that they end. Being prepared (by following the six tips above) can help you get through difficult economic times.