How to Prepare for a Recession: Ways to Protect Your Money

Many people are feeling the pain of the current economy as the high costs of essential goods and services, particularly housing, utilities, and groceries, strain household budgets. While the risk of a major recession has faded, inflation has proven sticky, and interest rates remain high. Economic growth has expanded, though this performance masks ongoing financial hardship.

Whether the country heads into an official recession or not, it’s important to understand that downturns are a normal part of economic cycles. There are also steps you can take when the economy is slowing to safeguard your financial health and avoid being significantly affected by a recession. Here are some key strategies to consider taking now, as well as actions you may want to avoid should the economy take a turn for the worse.

What Happens During a Recession?

A recession is a significant decline in economic activity that is spread across the economy and lasts more than a few months. One rule of thumb is that two consecutive quarters of negative gross domestic product growth indicate a recession, but a number of formulas are typically used to determine recessions.

During a recession, several economic indicators show a downturn:

•   Employment rates drop

•   Consumer spending decreases

•   Business revenues fall

•   Overall economic confidence wanes

This environment can lead to higher unemployment rates, decreased consumer confidence, and a general slowdown in economic activity.

Recessions are part of the economic cycle, which is characterized by peaks of growth followed by downturns. These phases of contraction can be triggered by various factors, including high inflation, rising interest rates, decreased consumer spending, or unexpected global events, such as a pandemic. Understanding the mechanics of a recession can help you take proactive steps to protect your finances and minimize the negative effects.

How to Prepare Your Finances for a Recession

Recessions are a possibility in any economic cycle, and you can avoid some of the negative impacts by anticipating challenges early.

Take Stock of Your Finances

Higher prices for everyday goods and services have already forced many consumers to cut back their budget for basic living expenses, such as groceries and travel. Even if you’ve made some spending adjustments, it’s a good idea to check in on your finances. You can do this by scanning the last few months of financial statements and assessing your average monthly spending and average monthly take-home income.

If you find that your spending is close to your earnings (meaning you’re not saving) or it’s higher (meaning you’re going backwards), you’ll want to review your discretionary spending and look for areas to cut. Doing so can free up funds to increase savings and pay more than the minimum on any debt.

Build a Safety Net

Hard as it may be to find extra cash, it’s important to make sure you are putting funds aside each month toward building your emergency fund. This fund will serve as a financial cushion if you experience a job loss or get hit with any unexpected expenses. If you already have an emergency fund, consider increasing it to provide extra security during uncertain economic times.

The general rule of thumb is to keep at least six months’ worth of living expenses in a separate, easily accessible account. But if that feels like an overwhelming goal, it’s fine to start slow. Even transferring $50 a month to your safety net can add up significantly over time. To maximize the growth of your emergency fund, choose an account that pays a competitive annual percentage yield, such as a high-yield savings account.

Pay Down High-Interest Debt

Here’s the bad news about higher interest rates: the national average credit card rate is 20.97%, which makes credit card balances a significant financial burden. As a result, you’ll want to check the rates on all of your credit cards and other debts. If any variable rates have gone up, the next step is to pay as much as you can toward your highest-interest balances first to reduce that debt. This is the kind of debt that can, unfortunately, snowball during tough economic times.

You might also look into balance transfer credit card offers. They can provide a period of no or low interest, during which you can pay down that debt. Another option is to consolidate high-interest debt with a lower-interest personal loan. You might also look into a nonprofit debt counseling program.

Once you’ve eliminated high-cost obligations, you’ll be better prepared to manage any potential financial bumps in the road.

Stay Your Investment Course

For your long-term investments, such as 401(k)s and other retirement accounts, continue making your contributions or consider starting if you haven’t already, and try not to worry too much about market volatility. If you have a diversified portfolio, you generally don’t want to change your strategy out of fear of a looming recession.

For perspective, consider this: The Dow Jones fell nearly 3,000 points on March 16, 2020, which was the largest decline in one day in U.S. stock market history. Yet, the market rebounded quickly and set new records in late 2020 and early 2021. Investors who sold in a panic didn’t see any of those record-breaking returns.

If rising expenses are making it impossible for you to keep up with 401(k) contributions, try to contribute at least the minimum necessary to get any matching funds your employer offers. That’s additional retirement savings you don’t want to miss.

Recommended: How Much Should I Contribute to My 401(k)?

Recession-Proof Your Career

Recessions often involve layoffs and a significant rise in unemployment. This is something to keep in mind, especially if you work in an industry that typically suffers downturns in a recession. Reducing debt and building emergency savings, as mentioned above, are two important steps you can take to prepare for the financial shock of a layoff.

In addition, you may want to take steps to recession-proof your career. Start by updating your resume and optimizing your LinkedIn profile. If you notice any gaps in your skill set, particularly in artificial intelligence literacy or emerging industry tools, explore the certifications or training needed to protect your livelihood. It’s also smart to refresh connections within your professional network, looking both within and outside your organization to secure internal referrals. Having a strong network and staying adaptable to new skills and technologies can provide opportunities even during economic downturns.

What to Avoid Doing During a Recession

Here’s a look at what not to do if the nation slips into a recession.

Panic

While the term recession can be panic-inducing, you should avoid making any hasty decisions. Economists use the word recession simply to indicate that the economy is contracting, not growing. Not all recessions lead to double-digit unemployment or severe stock market losses.

That said, the stock market often experiences significant volatility during a recession, which can lead to fear and panic selling. As mentioned above, selling investments hastily could result in substantial losses. It’s often wiser to focus on your long-term investment strategy and avoid making impulsive decisions based on short-term market movements. Market downturns can also present buying opportunities for long-term investors.

Tap Your Retirement

Withdrawing from your retirement accounts should generally be considered a last resort during a recession. Early withdrawals can incur penalties and taxes and reduce the funds available for your future. Explore other options first, such as cutting discretionary spending, picking up a side gig for extra income, or using your emergency fund, before tapping into retirement savings. Protecting your retirement funds is crucial for long-term financial security.

Accumulate New Debt

Taking on new debt during a recession can increase financial stress and vulnerability. Ideally, you want to avoid making large purchases or using credit cards for nonessential expenses. It can also be a good idea to delay significant financial commitments, such as buying a home or car, until the economic situation improves. You’ll likely be better off focusing on maintaining a healthy debt-to-income ratio and preserving your financial flexibility.

Become a Cosigner

Cosigning a loan for someone else during a recession can expose you to significant financial risk. If the primary borrower defaults, you will be responsible for the debt, which can strain your finances and damage your credit score. During uncertain economic times, it’s best to avoid taking on additional financial liabilities that are beyond your control.

Take Your Job for Granted

Recessions can threaten job security, so avoid taking your employment for granted. Stay proactive in your role by demonstrating your value to your employer. Consider taking on additional responsibilities, seeking regular feedback, and continuing to build skills such as problem-solving, teamwork, and communication. Employees who demonstrate strong workplace skills may be better positioned in a competitive job market.

Recommended: The History of U.S. Recessions: 1797-2020

The Takeaway

Preparing for a recession starts with taking proactive steps to protect your finances and avoid common pitfalls. If a downturn may be looming, smart moves include building an emergency fund, reducing debt, continuing to save for retirement, and strengthening your job security. Equally important is knowing what to avoid, such as panic selling, accumulating new debt, and withdrawing from your 401(k) or IRA early.

Economic downturns are never pleasant and often painful. But with thoughtful planning and the steps outlined above, you can protect your finances and better position yourself when the economy recovers.

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FAQ

What is a recession?

A recession is a significant decline in economic activity that spreads across the economy and lasts for several months. It’s often associated with falling consumer spending, declining business revenue, and rising unemployment. Economists commonly use multiple indicators, including gross domestic product trends, to determine when a recession occurs.

How can I prepare financially for a recession?

Preparing for a recession often involves reviewing your finances, cutting unnecessary spending, and building an emergency fund. Paying down high-interest debt and continuing to save for retirement can also strengthen your financial stability.

Should I change my investment strategy during a recession?

Long-term investors are generally advised to stay focused on their overall investment strategy rather than react to short-term market volatility. Selling investments in a panic can lock in losses and prevent you from benefiting from market recoveries. Maintaining a diversified portfolio and continuing contributions (if you are able to) can help support long-term growth.

Is it a good idea to withdraw money from retirement accounts during a recession?

Withdrawing funds from retirement accounts is usually considered a last resort. Early withdrawals may trigger taxes and penalties and reduce the savings available for your future.

Photo credit: iStock/tolgart

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