Recessions are like natural disasters: They’re inevitable, but smart preparation may reduce the impact on you.
The U.S. economy has grown steadily since emerging from the Great Recession in June 2009, but expansions can’t continue forever, and this one is already the second-longest on record. Only the expansion from March 1991 to March 2001 lasted longer.
Recessions occur when growth stops and the economy starts to shrink. They vary in severity and length, but often jobs disappear, incomes decline and lenders make it harder to qualify for credit.
Knowing what may be coming can help you fortify your finances to withstand a possible slowdown. Here are some steps to consider.
1. Reduce your “must-haves.” The 50/30/20 budget suggests limiting your must-have expenses to 50 percent of your after-tax income, with 30 percent allocated to wants and 20 percent to debt payment and savings. Must-haves include shelter, transportation, food, utilities, insurance and minimum loan payments.
Limiting essential expenses ensures that you have room to pay off the past, save for the future and have a little fun. Capping them also helps during bad economic times, when you may need to sharply reduce your spending because of job loss or reduced hours.
2. Protect your credit scores. Lenders often get pickier during recessions. They may freeze lines of credit, close credit card accounts and make new loans harder to get.
People with good credit scores tend to fare better when lenders get choosy. Lenders need to stay in business, after all, so when delinquencies and defaults go up, they want to cultivate customers who are most likely to pay them back.
Because high scores suggest that you’ll pay as agreed, protecting your scores is essential. That means paying all your bills on time, using only a small amount of your credit limits, keeping old credit card accounts open and being selective about opening new accounts.
3. Increase your financial flexibility. Ideally, everyone would have an emergency fund equal to at least three months’ worth of expenses. But most people don’t have nearly that much saved, and building up such a stash can take years.
In the meantime, it’s smart to set up access to additional credit that you can tap if you lose your job or face other financial setbacks. If you own your home, you may be able to set up a home equity line of credit or replace your current line with one that has a higher limit. Having a few credit cards can help as well.
The key to the strategy is to keep these lines open and unused. (You’ll need to make a few small charges to keep the credit cards active, but you should pay the balances in full each month.) If you have credit card debt, focus on paying that down since you’ll free up available credit and save money on interest.
But don’t rush to pay off student loans or mortgages, especially if you have higher-rate debt or a paltry emergency fund. Your extra principal payments typically won’t reduce your required monthly payment, and you can’t get that money back if you need cash in an emergency. Although being debt-free is a good goal, in a recession it can be more important to have financial flexibility.
4. Update your investments. If your stock market investments include money you’ll need in the next five years, now is the time to move it to a lower-risk investment such as a short-term bond fund or cash.
You should be able to leave any stock market investments alone for at least five years and preferably 10, so your portfolio has time to recover from downturns.
Now is also a good time to rebalance your portfolio to your target mix of stocks, bonds and cash. The long bull market means that you may have too much money in stocks, which leaves you more vulnerable to drops. If you’re not in the habit of rebalancing at least once a year, consider using a target-date retirement fund, a lifestyle fund or a robo-adviser, which all take care of that chore automatically.
There won’t be tax consequences for these moves if you’re investing inside a tax-deferred account, such as an IRA or 401(k). Before making moves in a taxable account, consult a tax pro.
All of these steps make sense regardless of what happens with the economy. Taking them now can help you better handle whatever comes next.
