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Budgeting

Aug 2, 2022

How to prepare for a recession

By Stash Team
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If you’ve been watching the stock market lately, you might be feeling a bit worried, and you’re not alone. In a recent survey, more than two-thirds of people said they were anxious about rising inflation. What’s more, the Russia-Ukraine war, continued pandemic struggles, and other events are increasing market volatility. 

Recessions are a natural, albeit uncomfortable, part of the economic cycle, and typically are much shorter than times of growth. If a recession happens sooner than later, these tips may help you prepare for a recession while coming out steadier on the other side.

In this article, we’ll cover:

What a recession means for you

A recession is a natural part of the business cycle in which the economy contracts, meaning there’s a significant economic downturn across many sectors that lasts for more than a few months. This may show up as dips in income, spending, industrial production, and an increase in the unemployment rate.

Recessions affect individuals and businesses. As businesses struggle, they may lay off staff. When people are out of work, they often have less cash to spend and therefore consume less. This decrease in economic activity reduces businesses’ profits, and they may lay off even more workers to reduce costs. 

As companies lose value, the value of various types of investments, including those traded on the stock market, may also decline. When the recession subsides, however, many businesses recover, and portfolios may follow. Thus, buy-and-hold investors, who keep their money invested throughout all parts of the economic cycle, may build wealth over time despite recessions. Investors who panic and sell securities at a loss during a recession, however, could miss opportunities for long-term growth.

Five ways to prepare for a recession

Learning how to prepare for a recession can minimize its impact on your personal finances. For example, consider keeping tabs on your spending so you can cut back if necessary, paying off high-interest debt to avoid rising interest rates, building a fund for emergencies like being laid off, delaying nonessential financial commitments, and practicing buy-and-hold investing.

1. Review your monthly spending

Budgeting can help you reduce or eliminate expenses if your income goes down or prices go up. If your job is recession-sensitive, now may be the perfect time to make a budget. Here’s how to get started:

  • Calculate your monthly income. Include your paycheck, any self-employment or side hustle income, child or spousal support, investment returns, social security (if applicable), and any other income.
  • Capture your monthly expenses. Using bank records, note the name and amount of each expense you’ve had over the last three to six months. Include debt payments and contributions to savings and investment accounts. 
    • Tip: Remember to include expenses that don’t happen every month. For example, if your water bill is $90 every quarter, the monthly cost is $30, so plan for that in your budget.
  • Balance your budget. Compare your income and expenses. If you come up short, consider reducing non-essential expenses or starting a side hustle.
  • Set recession-friendly goals. Even if you’re in the black now, consider cutting discretionary spending to create more of a financial cushion. For example, you might pause a little-used gym membership or streaming service. What’s discretionary for one person may be essential for another, though, so set goals that match your needs.
  • Choose a budget system and begin. The 50-30-20 method is popular: 50% of your income goes to essential expenses, 30% to non-essentials, and 20% to savings and investment. For more budget systems and tips, take a look at this article.

2. Get rid of high-interest debt

Interest rates often rise during a recession, making debt more expensive. Experts consider some debts, like mortgages, car notes, and student loans, “good debt” because they meet essential needs and increase your net worth. On the other hand, some kinds of debt are considered “bad” because the items you buy rapidly lose value or don’t significantly improve your life. Here are the classic “bad debt” examples:

  • Credit cards
  • Personal loans
  • Unsecured lines of credit
  • Payday loans 

These types of debt also tend to come with high interest rates; many credit card rates are over 20%. When preparing for a recession, you might ask your lender for a rate reduction or move your balance from a high-interest credit card to a 0% interest card if you can. 

Paying off high-interest debt can be a smart move when you’re concerned about a recession. The avalanche method is a debt payoff strategy that aims to reduce the interest you pay by focusing on your highest-interest debt. Here’s how works:

  1. List your debts in order: highest interest rate to lowest.
  2. Decide how much you can pay toward debt every month.
  3. Pay the minimum for every debt, plus extra on the top debt.
  4. When the top debt is paid off, roll the extra payments to the next on your list.

Example of the avalanche method

As you pay off each debt, the extra money rolls down to the next, and the impact becomes greater over time. Let’s say an imaginary consumer, Avery, has the following debts:

DebtBalanceInterest RateMinimum Payment
Visa credit card$1,00020%$40
Discover credit card$1,00015%$40

Avery’s budget has enough room to put $150 a month toward debt payments. With the avalanche method, here’s what the monthly payments would look like:

Type of DebtBalanceInterest RateMinimum PaymentAvalanche Payment
Visa credit card$1,00020%$40$110
Discover credit card$1,00015%$40$40

After 10 months, the Visa would be paid off, and the Discover balance would be just over $750. Avery would keep putting $150 a month toward debt payments:

Type of DebtBalanceInterest RateMinimum PaymentAvalanche Payment
Visa credit card$020%$0$0
Discover credit card$756.6515%$40$150

After paying the Discover card balance for six months, Avery would be debt-free.

3. Build your emergency fund

Maintaining an emergency fund can be a wise practice whether markets are rising or falling. When a recession may be coming, adding money to your savings account can be even more important. 

Typically an emergency fund contains six months of living expenses. Having that extra cash can keep you afloat if you lose your job, experience a pay cut, or have some other financial emergency. If six months of savings is out of reach, saving even a month or two of income could help you through a difficult time.

Tips for starting your emergency fund:

  • Set up a monthly budget to identify your expenses and determine how much you’d need to get by for six months.
  • After making sure your necessities and debt payments are covered, devote a portion of what’s left over to emergency savings.
  • If you don’t have much left over or want to build your emergency fund faster, cut some discretionary expenses and put that money toward your fund.
  • Continue adding to your fund until you have enough to live on for six months. 
  • Keep your fund in a savings account so you can access it easily in case of an emergency.

4. Don’t make big financial commitments

One of the best ways to reduce expenses is to avoid new ones. When it looks like a recession might be on the way, it may be better to delay large purchases. If you don’t need that new couch or big vacation right now, you could put the money into your emergency fund. You may also want to hold off on anything that would increase your existing monthly expenses; this might not be the ideal time to get a more expensive apartment, move out of your parents’ house, or ditch your roommates.

Large expenses that require financing are especially tricky when a recession looms because you’re committing to a new monthly bill for a long time. Consider the example of financing a new car. Even if you can afford the payments now along with an increase in your car insurance, a car loan locks you into monthly payments for several years, which could put you in a bind if you lose your job or have a large emergency expense. As long as your current car is serviceable, you could put the money you’d spend on car payments into a savings account so you can spend it on car repairs as needed or use it for a new car when the economic outlook is sunnier. 

5. Continue to invest what you can

Staying invested in the stock market through all parts of the market cycle, with a diversified portfolio that aligns with your risk profile, could lead to long-term investing success. If you’re a buy-and-hold investor already, you might stay the course during a recession, continuing to make your regular contributions to your 401(k), IRA, and brokerage accounts. It may be upsetting if you see your account balances fall, but remember that many businesses will recover with the economy. 

If you aren’t investing your money yet, take your financial pulse first; if your expenses are well-covered and your emergency fund is stocked, investing during a recession isn’t necessarily out of reach. Some people see a recession as a good time to put money into securities that are temporarily lower-priced and hedge against inflation. Keep in mind that markets will always go up and down, and historically, recessions don’t last as long as growth periods. A robo-advisor might be a good way to find a portfolio that’s right for you to get started as an investor.  

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Hold on tight; smooth sailing is in the forecast

Anticipating recessions can be stressful, but focusing on what’s within your control and understanding how to prepare for a recession can be empowering. Most experts agree it’s wise to budget, pay off high-interest debt, and build an emergency fund regardless of the economic weather. And The Stash Way® , with its focus on buy-and-hold investing, can help you stay focused on building long-term wealth even if you’re weathering stormy seas.

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