How to prepare financially for a recession

What is a recession?

A recession happens when a country or region’s economy declines, and the gross domestic product (GDP), which represents the total value of goods and services produced, drops. When the GDP falls, the prices of oil or gas typically change significantly as well. Companies sell fewer goods and economic growth stops, leading to increased inflation and unemployment levels. The most notable U.S. recession in recent history occurred in 2008 following the collapse of the U.S. housing market. Although recessions are unavoidable and challenging to predict, learning the warning signs can help you prepare yourself financially when they do occur.

What are the warning signs of a recession?

Even financial experts can’t reliably predict the timing of a recession. However, some economic factors indicate the possibility. Rising unemployment rates, increased prices in commodities like oil, and a declining housing market can all indicate a recession might be on the horizon.

Turn data into insights with Excel

Make better decisions backed by data and insights

Learn more

An inverted yield curve represents one of the most used indicators of a recession in the U.S. This curve occurs when the yield, or how much income an investment generates, of 10-year Treasury bonds falls below short-term Treasury yields. In most economic climates the longer-term bonds maintain a much higher yield, but an uncertain economy leads to increased demand for safer, more stable bonds. As a result, the yield of the longer-term bonds decreases. An inverted yield curve often comes before a recession, but it might occur a year or longer before a recession is officially declared.

Tips for preparing for a recession

Create a monthly budget

Maintaining a budget is an important part of financial security no matter the state of the economy, but it’s critical during a recession. Get a head start by understanding how much you’re spending each month and what nonessential spending can be cut. Recessions often lead to layoffs and increased unemployment rates, which means you may need to rely on your emergency fund.

To create a monthly budget, start by creating categories that each of your monthly transactions fall under. Note which bills, like your rent, car payment, and health insurance, stay the same each month and can’t be reduced.

Limit your expenses

Once you’ve figured out your average monthly spending, you’ll be able to identify the discretionary spending that you can cut back on. Luxuries like expensive clothing, regularly dining out, and anything else that isn’t necessary to your daily life should be cut. Swap your annual trip for a staycation and redirect that money towards savings. As a rule of thumb, you should limit your discretionary spending to less than 30% of your net income.

Put extra money in your emergency fund

Your salary and the cost of living in your city will affect how much you can save, but even if you can’t save much, you should prioritize your emergency fund when preparing for a recession. The extra money you save from cutting back on your spending should go towards these savings. During a layoff you’ll likely be able to receive unemployment benefits, but they may not be enough to maintain your current lifestyle, including your rent and other fixed expenses. Financial experts recommend saving at least six months of expenses, although it’s OK to build up to this amount as fast, or as slowly, as your income allows.

Pay off your credit cards

High-interest debt, like credit card debt, can hold you back from adding savings to your emergency fund. Carrying a credit card balance each month adds a significant cost to your monthly budget and can be unsustainable if you lose your job during a recession. The less debt you have when a recession starts, the better off you’ll be financially.

Update your resume

In general, most people have less job security during a recession due to increased unemployment rates. As companies start to cut costs, layoffs can impact you even if you’ve been at your workplace for years. By preparing your resume ahead of time, you’ll be able to start the job hunt immediately if you are laid off. Although you might not end up using it, having an updated resume never hurts.

Don’t cut back on investments

You might be tempted to change your investment strategy during a recession, as the stock market usually declines due to companies laying off workers or struggling to expand. However, the stock market is unpredictable, and your investments won’t be affected by a recession in the long run. Recessions typically only last a year or so, which means even if you’re close to retirement, you shouldn’t drastically change the amount of money you’re investing.

Planning for an economic downturn requires thoughtful budgeting and financial sacrifices, but taking these steps provides security during challenging times. By cutting back on spending and prioritizing saving, you’ll be better prepared for the next recession.