By THE INVESTOPEDIA TEAM
June 6, 2022
In a sluggish economy or an outright recession, it is best to watch your spending and not take undue risks that could put your financial goals in jeopardy. A recession can impair your personal finances. Being prepared and taking a few simple steps to reduce your risks can help you weather the economic storm. Below are some of the financial risks everyone should avoid taking during a recession.
- When the economy is in a recession, financial risks increase, including the risk of default, business failure, and bankruptcy.
- Avoid increasing, and if possible reduce, your exposure to these financial risks.
- For example, you'll want to avoid becoming a cosigner on a loan, taking out an adjustable-rate mortgage, or taking on new debt.
- Workers considering quitting their jobs should prepare for a longer search if they decide to find a new one later.
- If you're a business owner, you might need to postpone spending on capital improvements and taking on new debt until the recovery has begun.
Becoming a Cosigner
Cosigning a loan can be a very risky commitment even in flush economic times. If the borrower does not make the required payments, the cosigner might have to make them instead. During an economic downturn, the risks associated with cosigning on a debt are even higher, since the borrower as well as the cosigner may face an elevated likelihood of losing a job or seeing a decline in business income.
Tip: Cosigning potentially leaves you on the hook for the life of a loan. Consider other ways to help the borrower if you can.
That said, you may find it necessary to cosign for a family member or close friend regardless of what is happening in the economy. In such cases, it pays to have some savings set aside as a cushion. Or, instead of cosigning, it may even be preferable to assist with a down payment or make a personal loan rather than leaving yourself on the hook for the cosigned loan.
Getting an Adjustable-Rate Mortgage
When purchasing a home, you may choose to take out an adjustable-rate mortgage (ARM). In some cases, this move makes sense (as long as interest rates are low, the monthly payment will stay low as well). Interest rates usually fall early in a recession, then later rise as the economy recovers. This means that the adjustable rate for a loan taken out during a recession is more likely to rise once the downturn ends.
Important: While interest rates usually fall early in a recession, credit requirements are often strict, making it challenging for some borrowers to qualify for the best interest rates and loans.
Consider the worst-case scenario: You lose your job and interest rates rise as the recession starts to abate. Your monthly payments go up, making it extremely difficult to keep current on the payments. Late payments and non-payment can lower your credit rating, making it more difficult to obtain a loan in the future.
Instead, assuming you have decent credit, a recession may be a good time to lock in a lower fixed rate on a mortgage refinance, if you qualify. However, be cautious about taking on new debt until you see signs the economy is recovering.
Assuming New Debt
Taking on new debt—such as a car loan, home equity line, or student loan—need not be a problem in good times when you can make enough money to cover monthly payments and still save for retirement. But when the economy takes a turn for the worse, risks increase, including the risk that you will be laid off or lose business income. If that happens, you may have to take a job—or jobs—that pay less than your previous salary, which could eat into your ability to pay your debt.
In short, if you are considering adding debt to your financial equation, understand that this could complicate your financial situation if your income declines. Taking on new debt in a recession is risky and should be approached with caution. Pay cash if you can, or wait on big new purchases.
Taking Your Job for Granted
During an economic slowdown, even large corporations can come under financial pressure, leading them to look for cost cuts. All too often that means layoffs.
Because jobs become so vulnerable during a recession, workers can't take finding another one for granted. Older workers retiring during a recession could see their income decline and their retirement portfolio suffer just as they start to draw it down.
Making Risky Investments
This tip applies to business owners. While you should always be thinking about the future and ways to grow your business, an economic slowdown may not be the best time to make risky bets. Early on in a recession is not the time to stick your neck out. Later, once the economy starts to show signs of a sustainable recovery, is the time to start thinking big.
Tip: Especially avoid investment projects that would require you to take on new debt to finance.
Borrowing to add space or increase inventory may sound appealing—particularly since interest rates are likely to be low during a recession. But if business slows down more—as it may during a recession—you may not be able to make interest payments on time. Wait until interest rates just start to tick upward and leading economic indicators for your market or industry turn up.
The Bottom Line
There's no need to panic in response to an economic slowdown, but you should pay extra attention to spending and be wary of taking unnecessary risks. Even in the midst of a significant economic downturn, there are many positive steps you can take to improve your situation and recession-proof your life. These include adopting a realistic budget, establishing an emergency fund, and generating additional sources of income.