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 increases the risks to your financial well-being. Being prepared and taking a few simple steps can help you weather the economic storm.
Below are some of the financial risks that should be avoided during a recession.
Key Takeaways
- When the economy is in a recession, financial risks increase, including the risk of default, business failure, job losses, and bankruptcy.
- Avoid becoming a co-signer on a loan, taking out an adjustable-rate mortgage (ARM), or taking on new debt.
- Don't quit your job if you aren't prepared for a long search for a new one.
- If you own your own business, consider postponing spending on capital improvements and taking on new debt until the recovery has begun.
1. Co-Signing a Loan
Co-signing a loan is a risky commitment even in flush economic times. If the borrower does not make the required payments, the co-signer will be required to make them instead.
During an economic downturn, the risks associated with co-signing on a debt are even higher, since the borrower as well as the co-signer may face an elevated likelihood of losing a job or seeing a decline in business income.
Co-signing 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 co-sign 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 co-signing, you might help with a down payment or make a personal loan rather than leaving yourself on the hook for the co-signed loan.
2. Getting an Adjustable-Rate Mortgage (ARM)
When purchasing a home, you have the choice of an adjustable-rate mortgage (ARM) or a fixed-rate mortgage.
Interest rates usually fall early in a recession and then rise later as the economy recovers. This means that the adjustable rate for a loan taken out during a recession is likely to rise once the downturn ends. The fixed-rate loan at recession pricing could be a better deal in the long run.
While interest rates usually fall early in a recession, credit requirements are often stricter, 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 nonpayment lower your credit rating, making it more difficult to obtain a loan in the future.
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 that the economy is recovering.
3. Assuming New Debt
Taking on new debt—such as a car loan, home equity line of credit (HELOC), 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, your 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.
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.
4. 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.
Experiences in the technology industry in 2022 provide a reminder of how fragile employment can be in the face of an economic downturn. With the threat of recession looming, large tech companies made drastic workforce cuts. In November 2022, Facebook parent company Meta Platforms Inc. (META) parted ways with 11,000 employees, while Amazon.com Inc. (AMZN) announced that it would cut 10,000 jobs. For both companies, they were the largest layoffs in their histories.
Because jobs become so vulnerable during a recession, workers can’t take finding another one for granted, so it is wise to think carefully before leaving a job when the economy is in a rough patch.
In addition, older workers retiring during a recession could see their income decline and their retirement portfolio suffer just as they start to draw it down. If the economy is tumbling as you near retirement age, it’s important to weigh your options. You might even hang in there for another year or so.
5. 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, it's time to start thinking big.
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 struggle to make the payments.
Wait until interest rates just start to tick upward and leading economic indicators for your market or industry turn up.
What Is a Recession?
A recession is a meaningful and extensive downturn in economic activity.
A common definition holds that two consecutive quarters of decline ingross domestic product (GDP) constitute a recession.
In general, recessions bring decreased economic output, lower consumer demand, and higher unemployment.
What Are the Biggest Risks to Avoid During a Recession?
Many types of financial risks are heightened in a recession. This means that you’re better off avoiding some risks that you might take in better economic times—such as co-signing a loan, taking out an adjustable-rate mortgage (ARM), or taking on new debt.
A recession is no time to panic, but you should be conscious of the potential for layoffs in your industry and the likely difficulty in finding a new job if you end up unemployed.
If you own a business, it is best to avoid overextending yourself with risky new investments until the inevitable turnaround begins.
How Can I Protect My Investments During a Recession?
There is no surefire way to position your investment portfolio during a recession. In some cases—particularly if you have a longer investment horizon that will give your assets time to recover from any losses during the recession—you may benefit from leaving your portfolio alone. This keeps you invested in the markets and poised to gain from an eventual recovery.
If you decide to make some changes to your investment strategy in response to economic concerns, there are ways to reduce your risk. Most stocks and high-yield bonds tend to lose value in a recession, while lower-risk assets—such as gold and U.S. Treasuries—tend to appreciate.
Within the stock market, shares of large companies with solid cash flows and dividends tend to outperform in downturns.
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 if necessary.
