Recessions happen when economic growth comes to a halt, and the economy begins to shrink. It’s a scary, but inevitable part of the economic cycle. Luckily, there are ways for you to prepare for a recession, which include taking steps like:
- Creating a budget
- Strengthening your savings
- Building your credit
However, these tasks are easier said than done. Especially when a recession has already begun, like the coronavirus recession we’re experiencing now.
We’ll get into the details of how you can prepare for a recession, and what action to take once a recession has started further below. First, let’s take a look at what exactly defines a recession.
What is a Recession?
Since the Industrial Revolution, there has been a trend of long-term macroeconomic growth in most countries.
However, short-term fluctuations in which slowdowns (and even declining performance) over the period of several months or years occur as well. These are called recessions.
Signs of a recession include:
- Lowered rates for the Federal Reserve
- Stocks in bear market territory
- Widespread unemployment
What Exactly is the Definition of a Recession?
Recessions are temporary periods of economic decline in which trade and industrial activity are scaled down or stopped.
Generally, recessions are defined by a fall in the GDP (gross domestic product) for two quarters in a row. However, the National Bureau of Economic Research (NBER) has simply defined recessions as, “declines in economic activity lasting a few months.”
Recession Definition: A decline in GDP that lasts for two consecutive quarters (6 months).
Most people aren’t tracking GDP on a regular basis. For the average person, a recession comes to life for them through:
- Failing businesses and banks
- Slow or negative production growth (of goods and services)
- Increased unemployment
What Leads to a Recession?
There is no single method for predicting how or when a recession is about to happen. Just like no one can predict which direction the stock market will go on any given day, no one can predict the economic cycle with 100% certainty.
However, that doesn’t stop people from trying. Economists have created some generally accepted predictors that can point to a possible recession:
- Leading indicators are economic factors that change before the rest of the economy goes in a particular direction and typically show changes in trends and growth rates. These leading indicators include the ISM Purchasing Managers Index and the Treasury yield curve, among other things.
- Officially published data from government agencies representing key sectors of the economy (such as housing starts and capital goods). Changes in this data can lead to or move with the onset of the recession.
- Lagging indicators (economic factors that change after the rest of the economy has gone in a particular direction) showing changes in trends and growth rates, such as unemployment.
The Recession Domino Effect
Usually, once one or more of these events that lead to a recession happens, more follow. Its a domino effect where one event can set off a chain reaction.
The Domino Effect: Something causes companies to reallocate resources and limit production and losses. As a result, these firms lay off employees. Then, these laid-off employees do not have reliable sources of income, so they reduce their spending. This reduced spending makes these businesses even more strained than before.
Now that you know more about what a recession is, you can learn how to prepare for the next one. Below are the steps you should take to prepare for a potential recession.
6 Steps to Prepare for a Recession
Even though historically all recessions have ended, and the economy has recovered (more or less), the prospect of facing one is still scary. However, there are a few steps you can take to recession-proof your finances and life.
Step 1: Breathe
When recessions hit, people are quick to become gloomy and unmotivated. You (and everyone else) are almost guaranteed to lose money (at least, on paper) and potentially even your job. The media will take your concerns and multiply them tenfold, saturating news outlets with more stories of doom to feed into insecurities.
You’ll turn to media outlets for information and be fed fear.
Avoid sensationalism and succumbing to fear. Instead, the first thing you need to do is to take a deep breath and accept that a recession is imminent. A recession is going to happen at some point in your life, and you can’t stop it, all you can do it prepare.
You need to develop a plan, which the 5 additional steps below will help you do.
Step 2: Develop a Spending Plan
If you’ve never had a budget or have trouble creating one, this is the time to learn. Knowing where your money is and where it’s going will help you adjust during tough times.
Budgeting is especially important when expecting a decline in income. A decline in income will interfere with your ability to cover your expenses, so your first step when developing a spending plan should be to pay bills strategically.
You need to understand which are expenses are necessary and which ones are not, so that you can prioritize accordingly.
Here are some ideas to help you start budgeting better:
- Research the 50-30-20 budget: This budget allows you to spend half of your after-tax dollars on necessities, and the other half on “wants,” savings, and debt repayment.
- Organize your spending: Use online tools or spreadsheets to remember and track your expenses. Having a good sense of your personal financial situation will help make future financial decisions easier.
- Cut excessive costs: Once you have determined where your dollars are going, find places to trim your spending. From here, you can bulk up your emergency fund and lower your debt load. Also, try to find ways to make extra money if possible (side jobs).
Step 3: Strengthen Your Savings
Most of you probably already have a savings account with some money in it. If not, now is a good time to start building an emergency savings fund up.
Either way, before a recession is a time to both strengthen your savings and make sure it’s in the right spot. Here are some steps you can take:
- Start with what you have and build it as much as possible. This can be difficult during a recession where you’re likely to experience a drop in income, which is why it’s so important to build it up ahead of time.
- If you’re able, now is a good time to switch to (or start) a high-yield savings account. Most banks have had to lower their yields in recent years, but some accounts can earn rates over 1.5% APY. This is in comparison to typical savings account interest rates that can be as small as 0.09%.
- Build your savings account over months by transferring money into it regularly, such as on every payday. If you can swing it, save your tax refund or any other large sources of money as well.
Last, your savings isn’t just what is in a bank account.
You need to keep an eye on your investment accounts as well. While you want to avoid withdrawing money from these accounts before retirement, you should still have a long term plan to continue to contribute to them, if possible.
Step 4: Build Your Credit
Not paying back debt during a recession is a surefire way to get behind and pile up interest. If you’re making minimum payments while still charging to the balance, debt can easily become too much to handle.
Here are three tips to keep your credit score high before and during a recession:
- Get ahead of the debt curve by moving high-interest debts to cards with an introductory 0% APR offer on balance transfers. With these, you’ll need a high credit score, and you might need to pay a balance transfer fee, but it’s well worth it to avoid high-interest charges. Also, pay off the debt during the promotional period, if possible.
- If you do not qualify for such an offer, try to make as many extra payments on high-interest debt. It might seem backward to spend more money on these debts during the recession. However, the faster you can pay off your credit card debt, the fewer interest charges you’ll incur, and the better off you’ll be.
- Finally, remember to take care of your credit. You might encounter hard times where you need to borrow money; you’ll get the best rates if you keep track of and build your credit score.
Step 5: Watch Your Real Estate
If you’re renting a property, and find yourself needing to make some extra money, you can reduce your expenses in a few different ways. You could consider getting roommates or negotiating a lower monthly rent, or even explore renting out a spare couch or room on Airbnb.
However, if you’re a homeowner or a potential homeowner, your plan before a recession should vary depending on whether you want to purchase a new home, sell your current one, or stay in it.
If purchasing a new home, make realistic goals for what you can afford, and have enough finances to cushion you after you purchase. Bulk up your savings and avoid buying “too much home.”
When purchasing a home, the lender may analyze your savings and require you to have several months’ worth of house payments. Save up more than the minimum amount so you can afford emergency repairs or interruptions in income.
If you plan to sell your home, the worst thing you can do is rush the process. Even though the last recession made house values plummet, the next recession may not. Recessions are unpredictable, so house values are as well. Values may fall, but it’s possible that they may stay stagnant. Watch the market carefully before choosing to sell and stay put if you have even a little doubt.
If you plan to stay put, you may reduce your home expenses by refinancing your mortgage at lower interest rates. Recessions can (and usually do) come with plummeting mortgage rates, which give homeowners a chance to refinance. Keep track of refinancing rates, because after lenders process the first wave of applications, they might drop the rates again.
Regardless of what you do, make sure you’re building up your savings to protect yourself from income interruptions. Save at least six months of expenses to be safe.
Step 6: Hone and Diversify Your Skill Set
One of the lesser-known but most important things to prepare for a recession is to hone your skills and expand your skillset. Before and during a recession, unemployment rises. This leads to companies laying off workers and downsizing.
However, this doesn’t mean that all companies stop hiring or expanding.
To best protect you from potential job loss, look for opportunities to take on new responsibilities at work. In other words, make yourself more valuable.
At the least, this can make employers recognize that you’re an indispensable employee. In the best-case scenario, this can lead to increases and promotions, which allows you to save money more easily in case of an emergency.
Plus, if you learn new skills, it will make it easier to find a new job or side hustle should you find yourself without a job once a recession hits.
What to Do If A Recession Has Already Started
First, don’t panic.
Panic will only cloud your judgment and lead to poor decisions. Here are four basic things to do if the recession has already started:
- Sit down with every member of your household and review your finances, budget, and overall financial plan. When everyone is on the same page, everyone can contribute ideas.
- Continue to reduce your expenses as much as possible by cutting discretionary spending. Cut back on transportation expenses by carpooling or even commuting by walking or bicycling. Stop going out to eat and try to cook at home from scratch.
- Keep saving, no matter what. Even during a recession, there are ways to save money. Contribute to retirement funds and savings accounts by putting aside as much as you can when you can.
- Finally, try to relax. Recession depression, although a mildly humorous term, is a real thing. Don’t let fear control you; intense feelings of paranoia can reflect poorly in your work and strain your relationships.
Recessions are scary, and it’s very likely that if you’re young, you’ve never lived through one.
Although the economy is very different from the last recession and no two recessions are the same, there is a lot of valuable advice in investing books, websites, and other people who have lived through recessions in the past.
Summary: How to Prepare for a Recession
Recessions are both inevitable and uncontrollable, but you can control how you choose to react to them.
It can be tough to be calm in the face of potential job and income loss, unpaid bills, and the risk of losing your home. That is why you need to think clearly to navigate the financial challenges of a recession and manage your stress.
Although nobody can predict when a recession will start or end, there’s one thing you can do: position yourself now to avoid the brunt of the recession. Jobs will come and go, but the downturn will end in an upturn.
Prepare now to weather the worst of the recession and be in a better position to benefit when the economy turns back. You’ll be glad you didn’t wait until after the recession hit to start worrying about the future!