By Tara Mastroeni, Contributor
June 6, 2022
During times of economic uncertainty, many people get more cautious with how they spend their extra cash. But if you’re also carrying debt, you may wonder how to prepare for a recession and how it could impact your finances.
Here’s why a recession may be a possibility in the near future and the various strategies that you can use to stay on top of your debt if a recession hits.
Strategies to Handle Debt Before a Recession Hits
Lisa Kirchenbauer, CFP and founder of Omega Wealth Management, stresses that managing your finances before a recession hits is all about striking a balance. While paying down debt is important, it may not be the smartest move if doing so takes away all your cash on hand.
After all, you may need to have an emergency fund if you’re unlucky enough to lose a job in the future. According to data from the Pew Research Center, 15% of American adults faced at least one bout of unemployment in 2020, the last year the U.S. saw a recession.
But if you’re determined to pay down debt while the economy is stable, here are some strategies that you can use to get closer to the finish line.
How to Pay Down Credit Card Debt
If you carry a balance on your credit cards, you can pay a lot in interest over time. According to the Federal Reserve, in March 2022, the average credit card interest rate was 16.17% on assessed interest accounts. However, Kirchenbauer points out that the rates on some cards can go even higher, especially for borrowers with lower credit scores.
Let’s say that you have $5,000 and your credit card’s variable APR is 16%. If you pay $200 a month, it will take you 31 months to pay off your debt and you’ll be charged $1,112 in interest. And with interest rates ticking up, you may end up owing even more in interest.
If your cards already have balances on them, Bruce McClary, senior vice president of membership and communications for the National Foundation for Credit Counseling, recommends talking to your lender.
He says that if your credit score has improved since you first applied for your card, you may be able to negotiate a lower interest rate, which could save you some money in interest charges overall.
How to Pay Down Personal Loans
If you’re struggling to manage the monthly payments on a personal loan, Kirchenbauer recommends figuring out whether it’s possible to move the debt to another financial product with a more affordable interest rate. She suggests looking into a 0% APR balance transfer card or a home equity line of credit.
However, moving debt can come with risk. If you pay off your personal loans earlier, it may come with a prepayment penalty, which is a fee your lender may charge you if you repay your loan ahead of schedule. Kirchenbauer adds that 0% APR cards and HELOCs may only be available to those with very good to excellent credit scores.
For those with low credit scores, Todd Christensen, the education manager with Debt Reduction Services, Inc, a nonprofit financial counseling agency says that reworking your budget may be your best bet. “It’s not fancy,” he says, “but cutting non-essential expenses or starting a side hustle to bring in extra income can go a long way toward helping you keep up with your payments.”
How to Pay Down Student Loan Debt
Most Americans with federal student loan debt can rest easy for now as their payments are on pause until August 31, 2022. And President Biden has been dangling the promise of student loan forgiveness for millions of borrowers.
Private student loan borrowers, on the other hand, may not be as lucky. Still, while there isn’t a widespread forbearance program, many lenders have offered extended forbearance options in the wake of the pandemic. For example, CommonBond is allowing its borrowers to access a special natural disaster forbearance program, which allows loans to stay in forbearance for up to 30 days beyond the end of the national emergency declaration.
Forbearance pauses your payments for a set amount of time while you get back on your feet and may be an option worth considering if you find you’re having trouble keeping up with your payments in the future. But, bear in mind that interest may continue to accrue on your loan, which means that this move may end up costing you more money in the long run.
How to Pay Down Your Mortgage
Unfortunately, according to Todd Huettner of Huettner Capital, the time to refinance your mortgage and lock in a lower interest rate has likely passed as the average mortgage rate is now over 5% (compare this to 2.65% in Jan. 2021).
Huettner says that if you’re in a situation where you have to choose which debt to repay, homeowners should try to prioritize making their mortgage payments because their home is likely their most valuable asset. “Even if you have to sell something valuable to make the payment, having a roof over your head is well worth the cost,” he says.
If you’re experiencing a temporary financial hardship like a job loss, you may be able to receive some assistance from your lender. Like student loans, many mortgage servicers offer forbearance programs for those in need of assistance. In situations where the hardship continues long-term, your lender can also help you explore more drastic options, such as a short sale.
While selling your home may not be ideal, in many cases, a short sale is considered a better option than defaulting on your mortgage and losing your home through foreclosure because the impact on your credit scores is less significant.
What Steps Should You Take if You Can’t Pay Off Debt?
Unfortunately, even if you follow the advice above, it may not always be possible to stay on top of your debt. Here are some steps you can take if it’s getting harder to keep up with your payments.
- Trim your budget: Trimming your budget should always be your first line of defense. Cutting – or even pausing non-essential expenses for the time being – can give you more breathing room to pay down your debts. If you’re concerned about ensuring that your money goes to the right place, consider setting up autopay, which allows your creditors to take the payment directly out of your account, or setting aside the funds in a separate savings account.
- Work with your lender: If you’re experiencing financial hardship, lenders may allow you to work out an alternative payment arrangement, such as temporarily pausing your payments while you get back on your feet or setting up a payment plan with a lower monthly payment or more affordable interest rate.
- Credit counseling: If you’re going deeper into debt, consider credit counseling with an accredited, nonprofit agency. Many reputable agencies offer counseling services at little or no cost to you.
- Debt consolidation: Debt consolidation lets you streamline multiple debt payments into one and can help you save on interest. Typically, borrowers do this by taking out a new loan and using the funds to pay off their existing balances. You may have to pay a fee on the new loan, which can add to your total borrowing costs.
- Debt settlement: With this method, your creditors agree to accept less than they’re owed in exchange for receiving payment through a court-appointed repayment plan. Kirchenbauer says to be aware that debt settlements are reported to the major credit bureaus and will have a negative impact on your scores, which can impact your ability to be approved for affordable financing in the future. Since debt settlement hurts your credit and you’ll likely have to pay legal fees, she says it should be viewed as a last resort.
Is a Recession on the Horizon?
When considering whether we’re headed for an economic downturn, it’s important to understand how the term “recession” is defined. By definition, the National Bureau of Economic Analysis (NBEA) considers a recession to be two consecutive quarters of economic decline in the gross domestic product (GDP). However, in practice, most financial experts tend to take a broader view, looking at declines in activity across the entire economy.
The NBEA shared in its latest analysis that the GDP shrank by 1.4% in the first quarter of 2022, leaving many to suspect that a recession may be in the cards. For instance, a new report from Deutsche Bank predicts a recession by late 2023 and analysts at Fannie Mae recently publicized a similar forecast.
Still, it’s important to remember that predictions are just educated guesses, and they may not turn out to be correct or provide the full picture of what will occur.
As Kirchenbauer points out, “The problem is that [the GDP] is a lagging indicator. We won’t know we’re in a recession until it’s already upon us. That makes it even more crucial to take stock of your finances and to think about how a recession might impact you.”
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