Before a Recession, Do This With Your Debt

Amid stubbornly high inflation and aggressive monetary policy from the Federal Reserve, experts at many prominent financial organizations – including Fannie Mae, Moody’s Analytics and JPMorgan Chase – say that the U.S. is expected to enter a mild recession in 2023. An October Wall Street Journal survey of economists puts the probability of a recession in the next 12 months at 63%.

So what should you do to get ready before a recession arrives?

One way you can prepare for a coming recession is to build an emergency savings fund that covers three to six months’ worth of living expenses. This safety net can keep you afloat in the event of job loss or other unforeseen economic circumstances. But even if you’ve established a healthy savings cushion, it can still be challenging to balance your finances in a recession if you’re burdened by high-interest debt. Here’s how you can manage your debt before a recession.

Take stock of your outstanding debt and log it into a notebook or virtual spreadsheet. You can request a free copy of your credit report from all three credit bureaus on AnnualCreditReport.com to identify all debts in your name and get more information about your payment history and amounts owed. For each debt category you have – credit card, auto loan, student loan, personal loan, mortgage and others – you’ll want to record the following:

Compiling all of your financial information in a single place will help you identify areas for improvement and manage your debt repayment progress. Here’s an example of what a debt spreadsheet might look like:

Since your interest rate is essentially the financing cost you pay to the lender to borrow money, your most expensive debts to repay will be the ones with the highest APRs. Unsecured debts like credit cards and personal loans usually carry higher interest rates than secured debts like a mortgage or auto loan.

Typically, a revolving debt with a high interest rate, such as a credit card that you don’t repay in full every month, will cost the most to repay over time. And because credit card interest compounds daily, it should be a top priority to pay down your balances. For example, if you’re making the $150 minimum payment on $5,000 worth of credit card debt at a 23.99% APR, you’ll pay about $3,300 in interest over the course of four-and-a-half years before you’re debt-free.

Paying down your credit card debt is a smart financial move, whether or not you anticipate a recession. Here are a few strategies for doing so:

Once you’ve paid down your credit card debt, you can contribute more income toward an emergency savings fund. And since your credit line is freed up, you can potentially tap credit card spending as a last resort if you’re experiencing economic hardship.

Although personal loans typically have lower interest rates than credit cards, unsecured personal loans are still usually more expensive to repay than secured loans. Let’s say you have a five-year personal loan worth $3,000 at a 17.5% interest rate. Even when you make on-time payments each month, you’ll pay more than $1,500 toward interest during the course of repayment.

If you have extra money to contribute toward your personal loan, it may be possible to make additional principal payments to get out of debt faster. Be sure to read your loan agreement carefully, as some lenders charge a prepayment penalty for paying off the loan early.

You might also consider refinancing your personal loan for better terms. You may be able to qualify for a lower interest rate if your credit has improved since originally borrowing the loan, or if you enlist the help of a creditworthy co-signer.

Most personal loan lenders let you prequalify with a soft credit check, so it doesn’t hurt to shop around for a better rate than what you’re currently paying. Locking in a lower interest rate can potentially reduce your monthly payments, which can help you balance your budget in the event of a recession. Just be aware of any loan origination fees that could offset your interest savings.

As for student loan debt, your repayment strategy likely depends on the type of student loans you have – federal or private. Federal student loans may be eligible for money-saving benefits such as income-driven repayment plans. Under IDR, your monthly payments are limited to a set percentage of your income, which can be as low as $0 if you’re laid off during a recession.

Additionally, federal student loan payments are paused as the Department of Education works to resolve lawsuits against President Joe Biden’s debt forgiveness plan. If you’re still unable to make payments when that pause expires, you may qualify for student loan deferment, unemployment forbearance or other federally mandated hardship protections. These programs can keep you afloat if you’re impacted by job loss in a recession.

On the other hand, private student loans aren’t eligible for federal benefits, which makes them a higher priority for repayment. And since private student loan interest rates are based on creditworthiness, some borrowers may have higher rates on their private loans than their federal loans, making them more expensive to repay.

If you want to pay down your private student loans faster or reduce your monthly payments, you might think about lowering your interest rate through student loan refinancing. But if you simply can’t afford your payments, reach out to the lender to see if you qualify for deferment or forbearance – although private lenders aren’t beholden to the same hardship programs as federal loan servicers.

Secured debts like an auto loan or mortgage may have more competitive interest rates than other types of debt, making them a lower priority to repay. But if you’ve already rid yourself of unsecured debt, consider tackling your auto loan first. Mortgages usually have lower interest rates and longer repayment periods than auto loans. And most importantly, mortgage debt comes with an added tax benefit compared with auto loans: You may be able to deduct mortgage interest from your taxable income.

There are a few steps you can take with your auto loans if you want to lessen your debt load before a recession. First, look at your loan agreement to see if you’re satisfied with your repayment terms. If you think you can qualify for a lower interest rate, you might benefit from refinancing your auto loan. Doing so can help you get out of debt faster and save you money on interest charges over the life of the loan.

But if you’re happy with your current auto loan terms – and if you’ve already met your other financial goals like paying off more expensive debts or building your emergency savings fund – you could consider making extra payments toward the principal balance.

While paying down your mortgage will likely be a lower priority than tackling other types of debt, you may still want to come up with a plan for managing your home loan before a recession. For example, if you’re at high risk of job loss in an economic downturn, reach out to your lender to get more information about mortgage forbearance and other hardship programs. That way, you’ll know your options if you’re impacted by layoffs.

It may also be possible to refinance your mortgage for better terms, such as a reduced interest rate or lower monthly payments. However, mortgage rates are hovering just under 7%, which can make it difficult for borrowers to lock in better terms by refinancing.

Since your mortgage contributes to an essential cost of living, staying on top of your monthly payments during a recession is a top priority. After all, you’ll need to pay for shelter, whether you rent or own a home.

As much as you can prepare for the worst, it’s not always possible to avoid financial hardship, particularly during a recession. If you’re having trouble managing your debt, but you can’t find success with the strategies above, you still have options for getting your finances back on track. Here are a few moves to consider if you need help repaying your debts:

Contact your creditors. Upon experiencing job loss or financial distress, you should get in touch with your creditors and lenders to explain your situation and learn about any hardship programs they may offer. Depending on the type of debt you’re unable to repay, you may be eligible for temporary measures like forbearance or reduced monthly payments.

Get in touch with a credit counselor. Nonprofit credit counseling agencies provide free or low-cost debt management services to consumers in need. A credit counselor may enroll you in a debt management plan to repay your creditors in affordable monthly installments based on your income and debt load. Credit counselors may also be able to negotiate with your creditors on your behalf to reduce your interest rate or monthly payments.

Consider filing for bankruptcy. Declaring bankruptcy is often seen as a last-resort financial strategy for good reason. Bankruptcy has an enduring negative impact on your credit, which can take years to rebuild. Filing for bankruptcy can be expensive and time-consuming, as you’ll typically need the help of an attorney. And depending on the bankruptcy chapter you choose, you may need to liquidate nonexempt assets like investment accounts, vacation homes and luxury cars. But if you’re drowning in debt you can’t repay, bankruptcy offers a fresh start.

The National Bureau of Economic Research, a government agency tasked with tracking economic cycles in the U.S. economy, defines a recession as “a significant decline in economic activity that is spread across the economy and that lasts more than a few months.” A recession meets these three criteria: depth, diffusion and duration.

However, not everyone agrees that a recession is inevitable in 2023. While gross domestic product declined during the first two quarters of 2022, it increased at an annual rate of 2.6% in the third quarter, per the Bureau of Economic Analysis. And the American economy added a better-than-expected 261,000 jobs in October, data from the Bureau of Labor Statistics shows. With these indicators in mind, Goldman Sachs economists predict there’s only a 35% chance of a recession over the next year. Morgan Stanley researchers say the U.S. economy will “narrowly” miss a recession in 2023, with mass layoffs unlikely.

Despite the mixed opinions on whether a recession will start, the U.S. economy is cyclical. It goes through periods of expansion and recession, which means that an economic downturn is always somewhere on the horizon. And in the current era of uncertainty, consumers should prepare for the worst and hope for the best – particularly when it comes to managing their finances.