Nov 9, 2023
How to prepare for a recession
If you’ve been watching the market, you know that a recession has been in the forecast for most of 2023. Although the economy has grown at a modest pace throughout the year, inflation and higher interest rates from the Federal Reserve have taken a toll on consumer spending, income, and production. And, whether current conditions are a short-lived downturn or another recession looms in the future, preparing now can help you weather whatever economic ups and downs may come.
|What is a recession?|
A recession is a period of significant but temporary economic decline affecting individuals and businesses across multiple sectors. Economic indicators include rising unemployment rates alongside dips in income, spending, and industrial production. It is a natural part of the economic cycle, historically lasting an average of 11 months.
If you’re unprepared for an economic downturn, you’re likely to experience consequences with potentially negative long-term financial impacts. But with some proactive readiness, you can avoid the financial vulnerabilities associated with job loss, financial instability, and other recession-driven hardships. These eight steps will help you make a plan to ride out an economic decline with confidence.
In this article, we’ll cover:
- Understanding your finances
- Creating a budget to stick to
- Building your emergency fund
- Getting rid of high-interest debt
- Living below your means
- Avoiding new financial commitments
- Securing your career
- Why you should continue to invest
1. Review your finances
First, evaluate your current situation. Compile a comprehensive overview that includes income, expenses, liabilities, and assets.
- Income: Total up your income from all sources, including your salary and any additional money you bring in from things like side gigs, child-support payments, and government benefits programs.
- Expenses: List all your monthly expenses and how much you spend on them. Categorize them into two groups: necessities like rent/mortgage, utilities, and groceries, and discretionary spending like entertainment, dining out, and treats.
- Debt: Gather the current balances and interest rates of all your debts. Be sure to include every kind of debt, such as credit cards, auto loans, personal loans, medical debt, mortgages, and student loans.
- Savings and investments: Add up the balance in all your savings and investment accounts; don’t forget to include any retirement accounts you have.
This information allows you to lay out a financial plan to guide you through a potential recession, as well as look ahead to long-term goals. Consider creating a visual representation like a spreadsheet or financial statement that allows you to assess your situation at a glance.
Having all of this information in one place can keep you from making panicked financial decisions in the face of economic uncertainty. Determine where you could make cutbacks if needed now, instead of scrambling to make ends meet if your income decreases or disappears later.
2. Create and stick to a budget
Making a budget is a fundamental step in planning how to prepare for a recession, particularly if you’re new to managing your personal finances. When uncertainty looms, there’s no better time to track and adjust your spending habits. Understanding your cash flow today and where you could potentially cut back tomorrow is vital, especially if your job is recession-sensitive.
Start building your recession-friendly budget by subtracting all your monthly expenses from your income; this will tell you whether you’re living within your means or need to trim expenses. With that information in hand, you can establish monthly spending limits for each expense category and set savings goals. This is the time to decide if you want to cut down on your spending in certain areas so you can bolster your emergency fund so you have more of a cushion in case of recession.
You may want to use the 50-30-20 budget guideline to simplify the process. Assign 50% of your income to essential living expenses like housing, food, utilities, and debt. Devote 30% to things you’d like to spend money on but could ultimately do without, and 20% to savings goals, your emergency fund, and long-term investments.
3. Build your emergency fund
Financial curveballs like unexpected expenses and job loss could have a bigger impact during an economic downturn. A solid emergency fund provides a safety net you can use to handle those crises without going into credit card debt or wiping out your other savings.
Building an emergency fund can be especially important during a recession, when economic decline can undermine job stability. The rule of thumb is to save up three to six months’ worth of living expenses so you can cover your bills in case your pay is reduced or you get laid off. While you might be able to receive unemployment benefits if you lose your job, they may not cover all your essential expenses or float you for as long as you need. Unemployment usually replaces only half your income and ends after 26 weeks in most states, so chances are you’ll need the extra money in your emergency fund to get by until you find a new job.
While three to six months of living expenses may seem like a lot to save up, you can make it feel less daunting by breaking that larger goal into smaller ones based on priorities. You might start by saving enough to pay rent for three months, then setting aside enough for your essential bills, and so on. Just getting started is what matters most.
If you want to grow your emergency fund faster, consider cutting some discretionary expenses and putting that money toward your emergency savings. If you get a bonus, tax refund, or other windfall, add it to this savings goal. Keeping your fund in a high-yield savings account can also help amplify your savings by earning interest, as well as ensuring your money is easy to access when you need it.
4. Prioritize paying off high-interest debt
High-interest debt is expensive, and it can keep you stuck in a rut of never-ending monthly payments that strain your budget and undermine your savings goals. Credit cards, personal loans, unsecured lines of credit, and payday loans are generally classified as “bad debt” because they tend to have high interest rates and steep late fees; the interest rates are also variable, meaning they could skyrocket at the lender’s discretion. Bad debt can even negatively affect your credit score if you’re late on a single payment.
If you’re worried about how to prepare for a recession, getting out of debt as soon as possible may be high on your priority list. And paying off credit card debt might be extra important: the average credit card rate in the U.S. is 27.80% as of November 2023. Even if you currently have a low rate, credit card issuers often hike their rates when the Federal Reserve raises interest rates during periods of inflation.
Consider attacking your high-interest debt before recession strikes by using the avalanche method. This debt-repayment strategy prioritizes paying off your highest-interest debts first in order to reduce the overall amount you spend on interest over time. As you pay off each debt, the extra money rolls down to the next, and the impact becomes greater over time. Here’s how works:
- Organize your debts by interest rate, highest to lowest.
- Make the minimum monthly payments on all of your debts, except for the highest-interest one.
- Every month, pay extra on your highest-interest debt.
- When the first debt is paid off, put the amount you’d been paying on it toward the debt with the next-highest interest rate.
- Repeat the process until all of your debts are paid off.
Here’s an example of the avalanche method in action. Imagine you have the following debts and can afford to put an extra $110 a month, over and above the minimum payments, toward paying them off.
|Type of debt||Balance||Interest rate||Minimum monthly payment||Extra monthly avalanche payment|
|Unsecured line of credit||$1,300||12%||$25||n/a|
After eight months, the credit card would be paid off, so you’d start paying an extra $150 on the personal loan; $150 is the total of the credit card’s minimum payment and the extra avalanche payment.
|Type of debt||Balance||Interest rate||Minimum monthly payment||Extra monthly avalanche payment|
|Unsecured line of credit||$1213||12%||$25||n/a|
Once the personal loan is paid off, you’d put an extra $190 toward the unsecured line of credit until all your debts are satisfied.
5. Spend less and stay frugal
While you don’t need to deprive yourself of every little luxury, it does help to adopt a frugal mindset while preparing for a potential recession. Reducing discretionary expenses can help you put more money toward your emergency savings.
When looking for ways to save money, use the financial plan and budget you’ve already created to distinguish between needs and non-essential wants, then make some choices in the name of frugality. Dining, entertainment, and impulse buying are some of the most common culprits in a ballooning budget, so many people find that reducing these expenses can have a big impact.
- Limit dining out: Meal planning and cooking at home takes more time than dining out or ordering in, but it saves money on food costs in the long run. You might be surprised at how much you really spend in this category. If your parent ever said, “We have food at home” when you wanted to stop at the drive-through, you might want to adopt that adage yourself.
- Reduce entertainment expenses: Spending on events, travel, and hobbies can add up quickly, but you can have fun without breaking the bank. Keep an eye out for low-cost entertainment alternatives like home streaming services, free community events, or hobbies that don’t require expensive supplies.
- Suspend subscription services: There are a vast number of options for entertainment delivered right to your home: movie and music streaming services, mobile apps and games, monthly product deliveries, and many more. In many cases people rarely use most of the services they subscribe to. Review all of your subscriptions and consider canceling or temporarily suspending those that don’t truly feel worth the money.
- Curb retail therapy: Everyone wants a little treat from time to time, but impulse buys and regular retail therapy can take a toll on your budget. Remove the temptation to buy on impulse by deleting your payment information from websites that store it, and carry only cash when you’re shopping in person so you can’t spend more than you have in your pocket. Institute a 24-hour rule before you buy something that’s not in your budget; you might find that the urge to spend fades if you wait a day.
6. Avoid new, big financial commitments
When preparing for a recession, signing up for new expenses puts you on the hook for things you might not be able to afford if your cash flow starts to dry up. Avoid making new financial commitments, especially those with high monthly payments or interest rates. Forgo taking on new debt, stick with your roommates or your parents for a little while longer, and say no to pouring money into risky new ventures.
- Mortgages: The beginning of a recession often sees rising interest rates, so the timing isn’t great for locking yourself into a fixed-rate mortgage. Instead of buying real estate, save for a downpayment so you can buy that house when conditions are more favorable.
- Car loans: Getting more miles out of your current car instead of buying a new one keeps you from signing up for payments you may not be able to afford if recession hits. Funnel the money you’d spend on those car payments into your emergency fund or a sinking fund you can use to repair your existing vehicle.
- Large personal loans: Going into debt should be a last resort when preparing for a recession, and that includes borrowing significant sums of money for non-essential purposes. If you need a personal loan to buy something, it may be wiser to put that purchase on hold and save up for it instead so you’re not committed to monthly payments and interest.
- Business ventures: Starting a new business is a risk under any circumstances, but even more so during a recession. An economic downturn is likely to significantly curb consumer spending, leaving you without the customers and cash flow you need to succeed. Use this time to shore up your business plan and save so you can launch your venture when economic indicators are more favorable.
7. Cushion your career
Financial preparedness includes both enhancing your job security and focusing on career development, just in case you need to make an unexpected change. When you make yourself indispensable in your current position, you might be in a better position to weather potential layoffs. But if you do wind up in the market for a new job, ongoing professional development efforts could help you get noticed and hired faster. In either case, it’s important to know your industry, stay up to date with trends, learn new skills, and network before a recession hits. Consider taking these steps to stay ahead:
- Diversify your skill set: Identify and acquire skills that are in demand across various industries. Diversifying your skill set can make you more adaptable during economic downturns, especially if your specific industry takes a harder hit.
- Update your resume: Job searching can be stressful, especially when you haven’t updated your resume in a while. Give yourself some peace of mind and polish it up now. You’ll be more prepared to make a move, whether your company decides to downsize or an unexpected job opportunity pops up.
- Network, network, network: Landing a job often comes down to knowing the right people. Building a strong network of professional relationships can lead to new opportunities or fortify your job security in the midst of a recession. Stay in touch with colleagues on LinkedIn, join professional organizations, and attend industry conferences to grow your network.
- Stay informed about your industry: It pays to know what’s going on. Don’t ignore company news and industry reports. Stay informed about the health of your industry overall and monitor economic indicators so recession doesn’t take you by surprise.
- Deliver your best work: It may be difficult to stay positive and productive at work with economic uncertainty on the horizon. However, consistently delivering high-quality work, being flexible with company changes, and projecting optimism can enhance your professional reputation with your colleagues and boss. It can also help you obtain the glowing recommendation you need to snag your next job.
8. Continue to invest what you can
Perhaps the most important thing for investors to remember when recession looms is this: don’t panic. Even when the stock market is in a slump, don’t abandon your investing plans. While it may be stressful to see the value of your portfolio drop, remember that economic downturns don’t last nearly as long as periods of economic growth. A long-term investment strategy is intended to help you ride out market volatility and natural fluctuations in the business cycle, including a recession.
As long as your spending is under control and your emergency fund is solid, continuing to invest now can help you work toward retirement and other far-off goals. Keep making your regular contributions to 401(k) and IRA. If you want to make adjustments to the holdings in your brokerage account, you might consider defensive stocks and other investments that may perform well in a recession to further diversify your portfolio. You might also want to talk with a financial advisor about the options that best align with your goals and risk profile.
When recession looms, take the long view
Determining how to prepare for a recession involves taking stock of where you are now as well as your long-term goals. When you’re uncertain about the immediate future, it can help to get a firm handle on your personal finances to build a solid budget, emergency fund, and plan for paying off debt.
At the same time, remind yourself that economic recessions are temporary and recovery will follow. Staying invested throughout the ups and downs of the market cycle is key to reaching long-term investing success.
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