Financial Wellness

5 Tips to Prepare for an Economic Downturn

(4 Minute Read) – An economic downturn can be scary for many. But the reality is that economic downturns occur periodically as the economic environment needs to cool down.

When the economy is strong and growing, that pushes financial factors like inflation to an often uncomfortable point. With the rising costs that come with inflation, a slowdown in economic growth—such as a recession—can help bring those costs down. This cycle of expanding and contracting is par for the course of the U.S. economy. 

But sensing an economic downturn on the horizon can cause some panic. For example, the unemployment rate could increase as businesses tighten their financial reigns. This would then leave some searching for a new job. Additionally, interest rates are likely to rise in a downturn, as rate increases help stabilize inflation. This could then negatively impact the cost of borrowing for millions. 

These aspects create some warranted worry. However, there are steps you can take to prepare your financial life before an economic downturn takes place.

Check In With Your Cash Flow

One of the best first steps anyone can take as they prepare for an economic downturn is to evaluate cash flow. This means looking at the money coming in and money going out.

To start, simply add up all sources of income, from side hustle earnings to paychecks. Doing so can give a clear picture of how much money you have to work with each month or pay period. Next, you’ll want to look at the money going out. Because this can be difficult to track, it’s helpful to spend some time making a list of all monthly expenses, including the extras like travel, hobbies, dining out, and entertainment. Once you have this, add up all the various costs. With both figures in hand, you can then subtract total expenses from total earnings. 

If you have a deficit, meaning your total expenses are more than your total earnings, now is the time to take action. You can start by looking at the extra expenses to see if anything can be reduced or eliminated. This might involve limiting the number of times you dine out per month or canceling a subscription you no longer use. But suppose this exercise doesn’t create a positive cash flow, where income exceeds expenses and money is left over each month. In that case, it may be necessary to evaluate required expenses. This can include fixed expenses, like housing costs, car expenses, food, and utilities. By doing this, you can identify areas where changes can be made to improve cash flow.

Build a Budget

Having a budget is just as important as understanding cash flow. A general rule of thumb is to spend 50% of your income on needs like housing, utilities, and food. The next 30% of income is meant to be used on extra expenses, such as traveling, entertainment, or dining out. Then, 20% of income can be used for savings and paying off debts.

With a budget, it can be easier to work through your cash flow in the future. By having a clear picture of your expenses and income each month, you can continue to identify areas that you may be overspending in. This can then allow you to make any necessary changes to ensure you’re still able to afford your fixed expenses.

Focus on Savings

Along with adjusting expenses as needed, focusing on savings is beneficial. There may be fewer jobs available during an economic downturn, and companies may have to lay off staff to help reduce their own costs. This can leave individuals in a place where their income is in flux or lower than they’re used to for a while. Having a solid cushion of savings can help mitigate some of this risk. 

Experts suggest setting aside at least three to six months’ worth of expenses as emergency savings. This emergency fund can help cover unexpected bills or big-ticket items that inevitably come up. But note that preparing for an economic downturn may mean saving more than usual. For instance, if you have a three-month emergency fund, you might consider what can be done to increase that to four, five, or six months set aside. However, each person’s situation is unique. Therefore, it’s important for those without any savings to start by setting aside what they can and work their way up. 

Eliminate High-Interest Debt

Another issue that arises during an economic downturn involves rising interest rates. One way to combat high inflation and a rapidly expanding economic state is to increase the cost of borrowing. The Federal Reserve accomplishes this by periodically increasing the Fed rate, which then impacts consumer rates. This typically means higher rates for mortgages, car loans, personal loans, and credit cards. 

Because of this, it’s worth seeing what you can do to eliminate higher-interest or variable-rate debts. When a balance is paid in full, it not only means having one less bill to pay—it also means reducing the impact of increasing variable-rate debt, like a credit card, on overall cash flow. If possible, paying more toward high-interest debts can bring down a balance much faster than paying the minimum. Along with this, it may be helpful to review cash flow to see what is available for debt repayment and whether you can make high-interest debt a priority item in your budget. 

Other options might include consolidation of high-interest debts. Doing this may provide for a lower interest rate on the same debts. Some may also find a balance transfer from one credit card with a high rate to one with a zero or low rate works well for this task. 

Whichever solution you choose, it’s essential to look at your own finances first. This way, you can ensure you’re taking the best steps for your situation.

Consider Lifestyle Changes

Although it’s easy to say, making significant lifestyle changes to prepare for a downturn in the economy is not as easy a task. If expenses are too high for income, or if there is a job loss or change, adjusting your lifestyle may become necessary quickly. That may look like downsizing a home or eliminating extras like travel and hobbies for a period. These changes can be jarring at any point, but they can feel even worse when they’re forced upon us and require immediate attention. 

To prepare for potential lifestyle adjustments, consider what can be done now. For instance, if housing costs are eating up a majority of your total earnings, evaluating alternatives may be worth it. Similarly, if your vehicle is the latest and greatest but costs an arm and leg each month, transitioning to a lower-cost model may be the best choice. 

The Bottom Line

An economic downturn is an inevitable part of life, but it doesn’t have to be an uncomfortable experience. Instead, you can prepare now by adjusting your financial life as needed. It’s best to start with cash flow to ensure your earnings exceed your spending. Then, it can be helpful to boost savings, evaluate debt, and adjust your lifestyle choices to help create a necessary cushion for whatever may come in the future.

Author: Melissa Horton, Enrich
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