When It’s a Recession, Should You Pay Down Debt or Save?

The economy has contracted for two consecutive quarters, which long has been the benchmark for officially entering such a downturn. However, some experts say this time is different, and that we are not in an actual recession.

Whatever your take is on the subject, there is little doubt that fears of an economic slowdown have increased as 2024 has rolled along.

So, if the worst should come to pass and the economy goes into a tailspin, what should you do: pay down debt, consolidate debt, or save?

Fortunately, you can — and probably should — do all three things.

Preparing for a Recession With an Emergency Fund

No one knows if a recession is coming, but it’s best to prepare as if tough economic times are right around the corner. Without a doubt, you are better off overprepared than underprepared.

Save enough money to survive three to six months

Your first step in getting ready should be to look at the size of your emergency fund. Do you have enough money put away to help get you through an extended period of tough times? Many experts suggest saving the equivalent of six months of expenses in an emergency fund.

Consider your financial situation

The rule of “six months” is a guideline, however. You can keep more or less cash in your emergency fund, depending on your financial situation. The key is to have a money cushion big enough to allow you to pay all your expenses should a sudden financial emergency strike, such as a job loss or another hit to your income.

Keep your emergency cash safe

Keep your emergency fund money in a safe and liquid account, such as a savings account or a money market account. Investing the money in stocks is too risky for an emergency fund, and putting the money in a certificate of deposit robs you of the liquidity you need to access the cash at a moment’s notice.

Preparing for a Recession by Getting Control of Your Debt

Once you have built an emergency fund, it is time to turn to your debt and get those debt payments down.

Carrying debt is unsettling at any time, but it can become downright frightening when a recession strikes. If your income dries up overnight, you could be just days or weeks away from being unable to keep up with your payments.

In addition, some debts — such as credit card debt — are becoming more expensive right now, thanks to the U.S. Federal Reserve’s ongoing campaign to repeatedly raise its target federal funds rate in the hope that slowing the economy will tame inflation.

When the Fed hikes this rate, credit card rates inevitably follow in the same direction, making debt much more expensive for those holding it.

So, whittle down debt now. Doing so will put you in a much better position should a recession come to pass. There are two chief ways to pay down debt.

The “snowball” method

Using this approach, you completely pay off your smallest debt before moving on to the next-smallest debt. The goal is to eliminate your debts one by one.

The snowball method may not be the most cost-effective way to pay down debt, particularly if you have larger debts with higher interest rates. But some experts believe that each time you pay off a debt — even if it’s small and has a low interest rate — you get a rush of motivation that makes it more likely you will stick with your debt-reduction plans over the long haul.

Paying down the costliest debts first

With this approach, you attack larger debts with higher interest rates first, even if it will take a longer time to pay off the debts completely. This approach will likely save you money compared to using the snowball method because you are ridding yourself of the most expensive debts.

However, some people find this approach to be frustrating, because it may be a long time before they completely pay off even one of their debts.

Try the approach that seems best suited to your situation and temperament. If your debt is overwhelming and you are not sure about what to do, seek the help of a professional. For example, you might want to contact a nonprofit credit counselor.

Consolidate your debt

Another good option for getting control of multiple debts is to bring all your obligations together in a debt consolidation loan. This gives you just one payment to worry about, rather than several. And if you are lucky, you might even reduce the interest rate attached to your debt, which can save you money.

Applying for a personal loan is another way to work toward eliminating debt. You can use the proceeds from the personal loan to pay off your obligations. This works best if the interest rate on your personal loan is lower than the interest rate on your debts. Shop the best personal loans to find the best interest rate.

Saving Money to Prepare for a Recession

Once you have built an emergency fund and paid off some debts — or at least made a sizable dent in them — you can turn to the goal of saving more money.

You might think that saving money only makes sense in good times when you don’t have to worry about an economic earthquake shaking your financial foundation.

But whether times are good or bad, it almost always makes sense to save more money if you can.

For virtually all of this year, the stock market has been declining. But historically, the best time to buy stocks has been as they are falling.

Buying stocks when they are down makes them cheaper, and scooping up stocks at bargain prices traditionally has paid off handsomely when the economy — and the stock market — recover.

Even if you are reluctant to invest in stocks, you should still try to save more money. In fact, the reward for saving money today is greater than it has been in recent years.

The same U.S. Federal Reserve rate-hiking campaign that hurts those with debts actually can help savers. That is because when interest rates climb, banks, credit unions, and other institutions typically raise the rates they pay out on savings accounts, CDs, and other products.

So, if you increase your savings, chances are good that you will be rewarded with a higher return on the cash than you would have gotten in previous years.

More Steps to Help You Prepare for a Recession

There are other ways to prepare your finances for a recession.

For example, look for ways to cut your expenses now so you can save a bit more money. Tightening your belt in this way will get you comfortable with spending less, making it easier to rein in spending during any future recession.

Also, by spending less, you free up more money that can go toward paying down or consolidating your debt, building up savings, or both.

Other tips for getting ready to ride out a recession include:

1. Update your resume. Recessions and widespread job losses go hand in hand. So, it’s best to have your resume ready just in case the worst comes to pass and you are let go from a job.
2. Learn new skills. The workers most likely to avoid being laid off are those most valuable to their company. Make sure you possess the skills your employer needs.
3. Consider taking on part-time work or a side hustle. Yes, a recession may be on the way. But for now, plenty of job opportunities remain. So, this might be the time to take on part-time work and generate more cash so you have a bigger buffer when the economy turns sour.
4. Re-evaluate your career. If the economy drifts toward recession, it is possible you will lose your job no matter what you do. Although there is nothing good about a layoff – at least in the short term – make the most of the situation by re-evaluating your career and deciding if you want to change direction. If the answer is “yes,” use this time to enroll in a program that will help train you for a brighter future.