How to Prepare for a RecessionBuilding Wealth
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The American economy has already faltered in response to the COVID-19 pandemic, and it’s impossible to predict how long it could take things to get back to normal. Millions of Americans have already lost their jobs, and the unemployment rate has only continued to increase.
Regardless of your job security or money situation, this is the perfect time to be proactive about your financial future. In this article, we’ll cover some of the most effective ways to prepare for the impact of a recession. Keep in mind that stimulus checks, expanded unemployment benefits, and other resources are also available.
What Is a Recession?
In general, recessions occur when economic activity — particularly spending — slows down for an extended period of time.
Probably the most commonly-bandied definition is two consecutive quarters of negative GDP growth. GDP is the monetary value of all the goods and services produced in a period of time, in this case, quarter-over-quarter.
Recessions can happen for a variety of reasons, and every recession has some unique characteristics.
2008 Subprime Mortgage Crisis
Prior to the coronavirus recession, the most recent major recession occurred in 2008 and was largely linked to subprime mortgages. Lenders offered a large volume of risky mortgages, which eventually led to a massive increase in foreclosures when debtors failed to pay back their loans.
Federal Economic Policy
Just as the federal government has stepped in to alleviate the effects of the current recession, the Bush administration injected $700 billion into the economy in 2008, mostly to protect failing banks.
Despite the bailouts, the recession didn’t officially end until June 2009. Furthermore, some industries had trouble returning to normal for even longer.
In fact, some experts believe that the economy never fully recovered after the subprime mortgage crisis.
What to Expect in 2020 and Beyond
Of course, there are a number of notable differences between the 2008 recession and what we’re experiencing now. While economists generally agree that the housing bubble was the most relevant factor in 2008, the current recession is largely due to forced shutdowns in response to COVID-19.
On the other hand, you shouldn’t assume that the economy will immediately recover once quarantine measures are rolled back. Some experts expect a return to normalcy in the next couple years, while others think that the 2020s could very well be a “lost decade” for many Americans.
Even if your industry has generally avoided the effects of coronavirus, there’s no way to tell what the economy will look like in three or six months, much less three or six years. All things considered, the safest strategy is to hope for the best while preparing for the worst.
Build an Emergency Fund
The simplest way to give yourself more financial security is to put some extra money into an emergency fund. This gives you money to fall back on in case you lose your job or run into any other unexpected circumstances.
While savings are particularly helpful during recessions, you should try to keep an emergency fund at all times. Without one, you may be forced to rely on other sources of funds such as credit cards, withdrawals from retirement accounts, or personal loans.
How Much Should I Save?
Something is better than nothing, so the most important step is simply getting started.
First, take a look at recent bank and credit card statements and set a savings goal.
Don’t worry if building up your emergency fund is a slow process at first. The more you save, the easier it will be to save in the future.
If you reduce spending by $50 in your first month, for example, you may be able to find another $50 in the near future.
Most experts recommend saving enough money to cover roughly three to six months’ worth of expenses. If that sounds like an unrealistic goal, start with something more attainable. Even just a few hundred dollars will go a long way in an emergency.
Saving money is a tough habit to get into, and you may have trouble staying motivated every month.
One of the easiest ways to keep moving toward your goals is to take savings out of your paycheck immediately instead of saving the “extra” money left over each month. In other words, saving should be your first priority after getting paid.
Depending on your employer, you may be able to request a partial direct deposit into your savings account. This approach earmarks money for savings and helps you avoid the temptation to spend it rather than putting it toward your emergency fund.
Of course, everyone experiences unique obstacles when trying to save money, so the important thing is to find a strategy that works for you. The psychological aspect of saving money can be one of the toughest challenges, especially for people who aren’t accustomed to budgeting.
Where Should I Keep My Emergency Fund?
With so many options out there, you may not know the best way to store your new emergency fund. There are a variety of account types, each with their own pros and cons.
For example, checking accounts generally come with extremely low interest rates in exchange for excellent liquidity. On the other hand, investment accounts give you the opportunity to earn better returns, but you could also lose a significant amount of money (particularly during a recession).
All things considered, a high-yield savings account is typically the best option for an emergency fund. These accounts provide substantially higher interest rates compared to traditional savings accounts.
Ally Bank, for example, currently offers an 1.25% APY for all balance tiers, while Wells Fargo savings accounts come with just 0.01%. That works out to a difference of more than $100 per year for a balance of $10,000.
While high-yield savings accounts may not match the average annual return on index funds or other investments, they also don’t come with the same level of risk. The point of an emergency fund is that you’ll be able to depend on the cash in a worst-case scenario, so you should avoid putting these savings into the market.
That said, the money you keep in a savings account may not be easily accessible. With that in mind, some people keep a small amount of savings in a checking account.
On the other hand, you can also cover short-notice expenses with a credit card and then move money from your savings account to pay the bill.
It’s also worth noting that high-yield savings accounts aren’t the only low-risk way to store savings. Certificates of deposit, for example, provide a set interest rate over a given period of time. While most certificates of deposit charge early withdrawal penalties, no-penalty CDs are also available.
Get Out of Debt
Like building an emergency fund, getting out of debt is almost always a good strategy, but it becomes particularly important in the context of a recession. Debts can be extremely difficult to pay off if you experience an unexpected loss or decrease in income.
Should I Focus on Debt or Savings First?
Whether to start with debt or savings depends on your specific situation.
Credit card debt, for example, often compounds at 20% or more per year, so any delays could cost you hundreds of dollars. Even high-yield savings accounts only offer a percent or two in interest, so it generally makes more sense to focus on credit card balances first.
On the other hand, personal loans and some other forms of debt typically charge much lower interest rates. Additionally, they sometimes come with prepayment penalties that reduce or eliminate the benefits of paying the balance off more quickly.
In cases like these, there’s nothing wrong with making the minimum payment while putting any extra cash toward your emergency fund.
Consider Debt Consolidation
Debt consolidation is a great option for anyone struggling to pay off high-interest debts or multiple balances.
In general, debt consolidation refers to the practice of transferring one or more debts to another account or creditor. This strategy provides two main benefits.
First, you may have the opportunity to reduce your interest rate, especially if you have a good credit history. Furthermore, if you have more than one balance, you can streamline the process of making payments and potentially reduce your monthly payment by consolidating them into a single debt.
Balance-transfer Credit Cards
Many credit card providers offer cards specifically designed for balance transfers. These credit cards offer 0% APR for an introductory period, giving you time to pay down your debt without worrying about interest.
The downside of this strategy is that you’ll have to pay a balance-transfer fee upfront (typically around 3%). This might sound like a lot, but it’s significantly less than you’ll spend in annual credit card interest.
For example, 3% of a $10,000 balance is $300. A $300 charge could turn you away from the idea of a balance transfer, especially if you don’t know how much you’re already paying in interest.
At a 20% APY, that same balance would grow by $2,000 in just one year. In short, the balance-transfer fee is a small price to pay in exchange for interest-free payments.
The Capital One SavorOne Cash Card, for example, comes with no interest for the first 15 months, more than enough time to make up for the 3% charge.
Debt Consolidation Loans
Debt consolidation loans are another popular option for people struggling to pay back large balances. If you’re able to find an offer with favorable terms—such as a lower interest rate—they could help you save a substantial amount of money.
While debt consolidation loans can be an excellent tool in the right situation, they aren’t always the best option. It’s important to carefully look over the terms of a potential loan before making any decisions.
For example, many providers try to attract debtors by advertising low monthly payments. Paying less each month sounds good, but it will actually give your balance more time to grow due to compound interest.
Even with a lower interest rate, you could end up spending more money overall if the loan lasts for a longer period of time.
Avoid Going Back into Debt
Becoming debt-free is a major milestone, but many people have trouble preventing themselves from taking on new debts later on. Getting out of the habit of using debt to cover expenses is a great way to improve your financial future.
There are a few strategies that can help reduce your reliance on debt. Start by focusing on the basics—removing unnecessary costs from your budget, avoiding impulsive purchases, and developing an emergency fund to fall back on.
Of course, this isn’t to say that debt should always be avoided. Credit cards are a convenient way to spend money, and many cards come with cash back and other rewards.
You may also need to take on mortgages, auto loans, or other forms of debt for major purchases.
In general, the simplest way to avoid running into trouble with debt is to stop yourself from using it to cover costs you can’t afford. Pay off your entire credit card balance every month, forecast how monthly payments will fit into your budget before taking on new loans, and try to save for purchases in cash rather than using debt.
Reconsider Your Asset Allocation
If you have a retirement account such as an IRA or 401(k), your portfolio has likely lost a significant amount of value over the past few months.
This doesn’t mean you need to panic. recessions are a natural part of the market cycle, and you don’t actually lose money until you sell. That said, recessions are a good reminder of the importance of thoughtful asset allocation.
Stocks and Bonds
Stocks and bonds are the two most common types of assets for people investing in retirement or brokerage accounts. Keep in mind that you don’t have to buy individual stocks or bonds to invest in these assets—index funds, for example, track market indexes, while bond funds offer diversification by splitting your investment among a variety of different bonds.
Historical data suggests that stocks tend to perform better than bonds over time, but they’re also far more volatile. In other words, putting more money into bonds will likely lead to smaller gains over the long run, but you’ll lose less money during recessions.
Adjusting Your Allocation Near Retirement
These short-term fluctuations aren’t much of an issue if you’re planning to retire in 20 or 30 years. Your portfolio will have more than enough time to recover from a temporary recession.
On the other hand, you may want to start putting more money in bonds as you get closer to retirement. Keeping too much of your portfolio in stocks could force you to sell stocks to cover expenses during a recession.
In general, it’s good to put money in bonds if there’s a chance you’ll need to withdraw it in the near future. That said, people who are more than ten years away from retirement should invest almost exclusively in stocks to maximize their long-term gains.
If you have 20% of your portfolio in bonds, for example, you can withdraw from that money during a recession to avoid locking in any stock losses. Once the recession ends, you can rebalance your asset allocation to make sure you keep a constant 20% in bonds rather than leaning too heavily on stocks.
It’s easy to put off saving for retirement, but you should begin to think about this long-term goal as early as possible. Many people who wait too long to save for retirement have trouble building the portfolio they want when they start saving in their 40s or 50s.
While timing the market is never a reliable strategy, recessions are an intuitively lucrative time to buy stocks. If you don’t have a retirement account, consider opening an IRA (individual retirement account) or 401(k) as soon as possible.
Both account types offer significant tax benefits, with the main difference being that 401(k) plans are typically sponsored by employers.
If you’re currently employed, you should also look into your company’s 401(k) employer match policies. Many businesses offer full or partial contribution matches up to a certain limit. For example, if your company provides a 50% match up to $2,500, you could turn that $2,500 into $3,750 simply by putting it into your 401(k).
Prepare for Job Insecurity
Some industries have mostly avoided the impact of the COVID-19 pandemic, but the ripple effects of a large-scale recession are impossible to predict. In short, you should start preparing to look for a new job now, even if you don’t expect to lose your current position.
Put Yourself Out There
Most people wait to look for job offers until they realize that they could be laid off. On the other hand, proactively looking for work is typically a more effective strategy.
You could find something better, and the worst possible outcome is that you’ll end up in the same situation you are now.
Regardless of your current work outlook, there’s no downside to checking listings in your area and sending your résumé to a few prospective employers. Even if you like your job, you can always use outside offers as leverage for a higher salary or other benefits.
Simply being familiar with the process of applying for jobs will also pay off during a recession. Every cover letter and interview provides valuable experience that will help you become a more attractive hire later on.
All things considered, there’s no reason not to look into opportunities that you may not be aware of.
A strong network is another excellent way to insure yourself against a recession. Industry contacts who can vouch for your skills and professionalism will go a long way when you’re looking for a job.
Of course, this only works if you network proactively rather than waiting for something to go wrong.
Networking practices vary widely from one industry to another, but updating your LinkedIn is always a good place to start. Make sure to have your contacts endorse any relevant talents so that potential employers can immediately see your skillset.
Learn New Skills
In general, the most reliable way to improve your job security is simply to develop more lucrative skills. Rather than staying where you are, look for ways to add to your toolkit and differentiate yourself from others in your field.
Very few roles are immune from job insecurity, but developing new skills will always have a positive effect on your career. You’ll increase your chances of keeping your current job while making it easier to find a new position after being laid off.
It’s natural to feel anxious during a downturn, but you can improve your financial outlook by taking a few simple steps. These tips will help you prepare for economic uncertainty as markets slow down in response to COVID-19.