Should You Save or Pay Off Debt to Prepare for a Recession?
A recession can wreak havoc on your finances. So it’s understandable if you’re worried by recent headlines. Economists are increasingly pessimistic, with those polled for Bankrate’s Third-Quarter Economic Indicator in October 2022 putting the odds of a recession at 65% in the next 12 to 18 months.
If you’re worried about a recession, there are steps you can take to safeguard your money. But you’re probably facing some tough choices since your paycheck will only stretch so far.
One big decision to make: Should you save money or pay down debt to prepare for a recession?
Saving vs. Paying Off Debt Before a Recession
There’s no hard-and-fast rule that determines whether you should save or pay off debt when you’re worried a recession is imminent. Often, the best move is to split any extra money you have in your budget between boosting your savings and reducing your debt.
Financial planners typically recommend a six-month emergency fund, but that’s just a general rule. The exact number you should aim for depends on your personal circumstances. You may be able to get away with three months’ worth, for example, if you’re young and healthy and you work in a field that’s relatively insulated from layoffs, like healthcare or education.
A bigger emergency fund has some obvious advantages: It buys you more time to look for a job should you get laid off. You’re also less likely to need to raid your retirement funds early to meet your short-term needs. Doing so can be costly, not just because of the taxes and penalties, but also because you may be selling investments while they’re down.
Of course, if you’re affected by a recession, you’ll want your bills to be as low as possible. Paying off debt will free up money in your monthly budget and save you money on interest. If you’re paying down credit cards, your savings will be especially significant, given that the average annual percentage rate (APR) is above 16% as of November 2022.
But here are some situations when you may want to prioritize saving over debt payoff, or vice-versa.
Rising interest rates are good for savers. Many of the best high-yield savings accounts now offer annual percentage yields (APYs) of 2% to 3%.
When Saving More Makes Sense
Consider making savings your top goal in the following situations — but keep making minimum debt payments, of course.
- You don’t have at least three months’ savings. Though a six-month emergency fund or even a 12-month emergency fund in some cases is considered the gold standard, it takes time to build this level of savings. At the very least, aim for a three-month emergency fund. Should you get laid off, that financial cushion will give you time to apply for new jobs and make your way through the hiring process.
- You’re worried you’re about to lose your job. If your company has announced layoffs or hiring freezes, you may want to double down on savings for now. The same goes for if you work in a field that’s especially vulnerable to economic downturns, like hospitality, real estate or retail.
- You don’t have high-interest debt. In the best-case scenario, you only have low-interest debt, like a mortgage, car payment or federal student loan. In that case, you may want to focus on boosting your savings to a level that you’re comfortable with.
When Paying Off Debt Makes More Sense
Paying off debt before saving more money makes sense if these circumstances apply.
- You’re already behind on payments. If you’ve fallen behind on bills, getting caught up is your top priority before you save money. Getting credit is often much harder during a recession. A downturn will be even more painful if you’ve tanked your credit score.
- You have credit card debt. Because credit cards have exorbitant interest rates and interest rates are rising, paying off credit card debt is typically a smart move once you have a three- to six-month emergency fund.
- You’re comfortable with your savings level. If you have a decent emergency fund and you feel your job is secure, go ahead and pay down debt if you prefer lower expenses to a bigger bank balance.
Robin Hartill is a certified financial planner and a senior writer at The Penny Hoarder. She writes the Dear Penny personal finance advice column. Send your tricky money questions to [email protected].