Figuring out how to manage money during a recession—or any crisis—can be difficult. As we face a potential recession thanks to the novel coronavirus, financial decisions take on a new weight. After all, financial policy may change during a recession, which can leave consumers with questions. For example, if the Federal Reserve lowers interest rates, should you borrow money during a recession?
While lower recession interest rates might sound appealing, there are lots of things to consider before borrowing money during a recession.
What Is a Recession?
A recession is a period of time when economic activity significantly declines. In the U.S., the National Bureau of Economic Research defines a recession as more than a few months of significant decline across different sectors of the economy. We see this decline in changes to the gross domestic product, unemployment rates, and incomes.
In essence, a recession is a period of time when spending drops, and as a result, businesses ramp down production, lay off staff and/or close altogether, which in turn causes a continued decrease in spending.
There are many possible causes of recession, and usually, recessions are caused by a wide variety of factors—including economic, geopolitical, and even psychological—all coinciding to create the conditions for a recession.
For example, a recession could be caused by a major disruption in oil access due to global conflict, or by the bursting of a financial bubble created by artificially depressed interest rates on home loans during a financial boom (as was partially the case with the 2008 financial crisis in the U.S.). And yes, a recession could be caused in part by something like a pandemic, which could create supply chain disruptions, force businesses into failure, and change spending habits.
As for how psychology plays a role in recessions, financial actors might be more likely to invest in a new business or home renovation during boom years when the market seems infallible. But when an economic downturn or recession starts, gloomy economic forecasts could make people more likely to put off big purchases or financial plans out of fear. In aggregate, these psychological decisions may help control the market.
In the case of a recession, for example, many people choosing not to spend out of fear could cause a further contraction of the market, and consequently further a recession.
Recommended: Investing During a Recession
How Does Financial Policy Change During a Recession?
Recessions are problematic in part because they destabilize the economy. In order to keep the market relatively stable, the economic policy might temporarily change.
The Federal Reserve, which controls monetary policy in the U.S., often takes steps to attempt to curb unemployment and stabilize prices during a recession.
The Federal Reserve’s first line of defense when it comes to managing a recession is often to lower interest rates. The Fed accomplishes this by lowering the interest rates for banks lending to other banks.
That lowered rate then ripples throughout the rest of the financial system and culminates in reduced interest rates for businesses and individuals.
Lowering the interest rate could help to stem a recession by decreasing costs for businesses and allowing consumers to take advantage of low interest rates to buy things using credit. The increase in business and purchasing might in turn help to offset a recession.
The Federal Reserve also may take other actions to attempt to curb a recession, like quantitative easing. Quantitative easing, also known as QE, is when the Federal Reserve creates new money and then uses that money to purchase assets like government bonds in order to stimulate the economy. The manufacture of new money under QE may help to fight deflation because the increase in available money lowers the value of the dollar.
Additionally, QE can push interest rates down because federal purchasing of securities lowers the risks to lending institutions. Lower risks can translate into lower rates.
Recommended: Federal Reserve Interest Rates, Explained
Downsides to Borrowing Money During a Recession
A recession might seem like a great time to borrow money. After all, if the Federal Reserve lowers interest rates, borrowers might be able to snag a great interest rate on loans. So doesn’t that mean you should jump on those new projects when you can lock in a low-interest rate? Not always.
It’s a good idea to consider the pros and cons of borrowing money during a recession before deciding on any new loans, no matter how appealing the recession interest rate is.
While it might seem smart to borrow during a recession thanks to those sweet recession interest rates, there are other considerations that are important in deciding whether borrowing during a recession is the right move.
First, while interest rates may be low, there still might be a heightened risk of borrowing during a recession thanks to other difficult financial conditions.
For example, it might be more difficult to make payments on debt during a recession. Difficult financial conditions like furloughs or layoffs could make it more difficult to make monthly payments on loans.
After all, regular monthly expenses don’t go away during a recession so borrowers could be in a tough position if they take on a new loan and then are unable to make payments after losing a job.
Additionally, it may be harder to find a bank willing to lend during a recession. Lower interest rates may mean that a bank or lending institution isn’t able to make as much money from loans, which may make lending institutions more hesitant.
Additionally, lenders may be reluctant to lend to borrowers who may be unable to pay thanks to changes in the economy. Most forms of borrowing require borrowers to meet certain standards in order to take out loans, and if a borrower’s financial situation is more unstable due to a recession, lenders may be less willing to lend.
When to Consider Borrowing During a Recession
Of course, there are still situations where borrowing during a recession might make sense. For example, consolidating other debts with a consolidation loan might be a good idea.
If you already have debt, perhaps from credit cards or personal loans, you may be able to consolidate your debt into a new loan with a lower interest rate thanks to the changes in the Fed’s interest rates.
Consolidation is a type of borrowing that doesn’t necessarily increase the amount of total money you owe, but rather it is the process by which a borrower takes out a new loan—with hopefully better interest rates and repayment terms—in order to pay off the prior underlying debts.
Why trade out one type of debt for another? Credit cards, for example, often have high-interest rates, so if a borrower has multiple credit card debts with high-interest rates, they may be able to secure a consolidation loan that has a lower interest rate. Trading in higher-interest rates loans for a consolidation loan with potentially better terms could save borrowers money over the life of the loan.
Having one loan to pay off instead of many loans may be easier than managing multiple payments each month. When a borrower is paying off a variety of credit cards, they might have to consider payment due dates, interest rates, and amount of each underlying debt when deciding on monthly payments.
Additionally, if the entire balance isn’t paid in full by the end of the billing period, compounding interest accrues, increasing the amount owed. Combine the underlying debts, the interest, and varying terms and conditions and a borrower might end up with a staggering, and seemingly insurmountable debt.
Consolidating debts with high-interest rates could both simplify repayment and allow you to pay lower interest. This type of borrowing may make sense during a recession where a borrower could lock in a better rate on a consolidation loan without increasing overall debt level.
When considering consolidation, borrowers may want to focus on consolidating only high-interest loans or otherwise comparing the interest rates between their current debts and a potential consolidation loan.
Interest rates on consolidation loans can be either fixed or variable, which means a borrower may be able to lock in a lower fixed interest rate during a recession, but variable interest rates mean that interest could rise as interest rates rise following a recession.
Additionally, just like many other types of loans, consolidation loans require that borrowers meet certain requirements. Available interest rates may depend on things like credit score, income, and creditworthiness.
Recommended: Fixed vs. Variable Rate Loans
Additionally, some lenders may charge upfront fees when it comes to consolidation loans, so borrowers considering consolidation should make sure to read the fine print before applying.
With SoFi, you can be assured that you will never be charged a hidden fee. In fact, SoFi consolidation loans have no fees at all, which means you can be sure of exactly what you’re getting.
It is important to remember that deciding whether or not to borrow during a recession, including taking out a consolidation loan, is a personal decision that depends on your specific circumstances.
If you think a consolidation loan might be right for you, SoFi offers consolidation loans with no fees and fixed or variable interest rates. Applying is quick and easy.
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Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.