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During a recession, creditors tighten lending standards, making good credit even more important.
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A recession can put you in a financial bind that may require you to access credit to cover expenses.
Paying down debt, building an emergency fund, and sticking to a budget can help you protect your credit.
Creditors tend to tighten lending standards during a recession, making good credit very important.
A recession is a period in the business cycle when economic growth slows down, unemployment rates rise, and prices stall at inflated levels. This can be a difficult time to get through unless you’re well prepared.
While a recession may not have a direct impact on your credit score, there can be issues that arise because of an economic downturn that can add up to a negative effect. Lay-offs, pay cuts, and higher-than-normal consumer prices can result in a financial squeeze that forces people to access credit to keep up with expenses. Here’s what you can do to prepare for the worst.
How to recession-proof your credit
The credit scoring models that calculate your credit score base their algorithm on several factors, notably how reliably you pay your bills and how much money you borrow at one time. These factors just so happen to be impacted by a recession, causing you to fall behind on payments or rely too heavily on credit. These are the pillars you will want to target in preparing your credit for a recession.
Here are a few strategies you can use before and during an economic downturn.
1. Pay off existing debt
One of the best moves you can make to recession-proof your credit is to reduce your debt load. If you have high credit card balances with expensive interest rates, this can put you in an unstable financial position. If you don’t have a high interest rate now, keep in mind that most credit cards have a variable interest rate, so that interest rate can increase during a recession. If that happens, your debt load can become more expensive.
Keeping debt on your revolving credit accounts will also increase your credit utilization ratio, which is the amount of credit being used compared to your total available credit. Credit utilization is the second most important factor in calculating your credit score. A high credit utilization ratio signals to lenders that you are in financial trouble and may not be able to pay back what you have borrowed. Credit utilization is considered on each credit account and all your accounts combined. You should keep these under 30% to avoid hurting your score, though the lower your utilization the better.
Take a look at your financial situation and if you can, take steps now by increasing your payments. For some that may find this difficult, consider increasing your income with a part-time job or side hustle, and add this income to your payments. During a recession, the less you owe the better.
2. Build an emergency fund
For most people, the worst byproduct of a recession is job instability. Without a regular income, meeting your financial obligations and expenses can be extremely difficult if you do not have savings to fall back on. Your credit accounts offer a tempting financial cushion for your costs, though it puts your credit score in a precarious position. An emergency fund can give you that cushion so you don’t have to immediately start borrowing money when you lose your primary source of income.
There is no better time than now to start building an emergency fund. Try to build at least four to six months of living expenses. During a period of economic uncertainty, there is nothing like having financial peace of mind that you have something to fall back on in the short term during a financial downturn.
3. Talk to your lenders
Sometimes the worst happens. Due to job loss or an unexpected increase in expenses, you may realize that you are going to miss a payment. In this case, reach out to your creditors as soon as possible to see if they have any relief options available. If you explain your situation, some lenders may not report your late payments to the credit bureaus if you have a history of paying on time.
During a time of economic crisis, lenders may have options designed specifically for people struggling to make ends meet. These can include payment deferment, adjusted repayment schedules, and lower interest rates. This could offer some relief until you can resume your normal payment schedule. Talking to your lender and taking advantage of these options can provide the help you need when you cannot make timely payments and want to avoid damaging your payment history.
4. Revise and stick to a budget
It’s always a good idea to maintain a healthy and responsible budget. But this becomes even more important during an economic downturn. When a recession happens, having a budget in place will help you see exactly where and how you spend your money and quickly adjust your spending if there is an increase in expenses or a reduction in income.
A budget helps you assess which expenditures you can live without and which you need to maintain your lifestyle. Revising your budget to cut out unnecessary spending can help you get through a difficult financial period and even if your income is not affected during a recession, following a budget will ensure that you are living within your means and allow you to save more.
Why recession-proofing your credit is important
Your credit score is always important, but definitely during a recession. If your scores are low, you will pay more because the interest rate will be higher, making borrowing money more expensive. Credit can be a crucial lifeline during a recession, but a recession can also make it harder to get new credit as lenders become more risk-averse and tighten lending standards.
The strategies that you use to protect your credit during a recession will help you and your financial situation in any economy. You have no control over whether a recession happens or not, but you can control your savings and spending so economic hardship doesn’t take a toll on your credit.