Updated: Aug 28, 2020
By their nature, recessions are difficult to predict. We usually don’t know when they are coming, and we never know how severe they will be or how long they will last.
Many people believe that paying off debt during a recession is the safest financial decision they can make. Although it may seem counterintuitive, let me explain why a recession is the worst time to pay off debt.
Debt is not evil
Despite what many people believe, debt is not inherently evil. Debt is simply a financial tool. The problem is that so many people do not know how to use this financial tool. Put simply, they use debt for all the wrong reasons.
Debt can make you wealthier if it is used wisely to fuel investment, such as buying a house, starting a business or getting an education.
Debt is bad when it is used to fund a lifestyle you cannot afford.
If you use debt to buy “things”, including cars, you are placing an anchor around your finances.
Why you don’t want to be in debt during a recession Here is a simple explanation of how carrying debt heading into a recession can cause a lot of financial pain.
When the economy was strong you were living a lifestyle you could not afford.
To pay for that lifestyle involved taking on credit card debt or other consumer loans.
That simply added an extra monthly payment on top of a lifestyle you could not afford.
This is what I call the “debt spiral”. If you are using debt to maintain your lifestyle, your monthly payments to service that debt increase over time. If you maintain the standard of living while adding a new monthly payment to service debt, you are likely to take on more debt.
This debt spiral can continue as long as two things are true.
You have a steady income that allows you to make your monthly debt payments.
Someone is still willing to lend you money.
During a recession, one or both of those things are unlikely to be true anymore.
A lot of people lose their jobs during a recession.
Lenders are much more cautious about who they lend money to.
At this point, the debt spiral draws to a painful conclusion.
The immediate impact is that you are forced to drastically reduce the lifestyle you were accustomed to. If your income is reduced or banks won’t lend you more money, you have no choice but to reduce your standard of living. Sometimes dramatically. Think about having to choose between the power bill and the mortgage payment.
At this point, you might be thinking that this all seems like a very compelling reason to pay down your debt during a recession.
Except, it isn’t.
The time to pay down debt is when the economy is strong and you have a secure source of income.
Once a recession is upon us, we need to completely change our approach to managing money.
During a recession, cash is a lifeline
When the economy is doing great and cash is easy to come by our financial priority should be on thriving and building wealth. Which means investing and paying down debt.
When the economy is in recession our financial priority should be surviving. Which means ensuring we have enough money to keep a roof over our heads and food on the table.
Everything else is secondary. Especially if you have lost your job or have seen your income decline for any reason.
That means cutting all non-essential spending until such a time that the economy and your income security has recovered.
You should absolutely continue making the minimum payments on all of your debts. The last thing you need is to destroy your credit score and have collection agencies chasing you down.
However, making additional payments to pay down the principal on your debt is non-essential and you need to consider if it still makes sense to continue.
Every dollar you pay against your debt (above what is required), is a dollar you won’t have access to if your savings run dry and you don’t have enough income to pay your bills.
Having cash on hand is the greatest source of security during a recession. The technical term for this is “liquidity”. Companies and households with the most liquidity are the ones that can most easily get through recessions.
Making additional payments against your debt reduces your liquidity.
What to do instead of paying down debt
When money gets tight, the next best thing to having a pile of cash on hand is reducing your monthly expenses.
Here are two options you might consider when it comes to consumer debt like credit cards during a recession.
Make only the minimum payments.
If possible, consolidate multiple debts into a single loan payment.
If you’re currently paying more than the minimum required payments on your loans during a recession, you can easily free up cash flow by reducing that payment to the minimum.
If you have a lot of consumer debt, the monthly cost to service that debt is likely a significant expense. This is especially true if your debt is spread over multiple credit cards and loans, which each have their own minimum monthly payment.
This is where a debt consolidation loan can be beneficial.
Debt consolidation is the process of rolling all your high-interest debt such as credit cards, payday loans, and other debt into a single payment with a lower interest rate.
3 Debt consolidation methods to consider
Refinancing your mortgage.
Using a Home Equity Line of Credit (HELOC).
Apply for a consolidation loan.
If you own your home and still have sufficient equity in your home, it might be worth a phone call to your mortgage advisor about refinancing.
Essentially you would increase your mortgage by the amount of your consumer debt and use those funds to pay out and close all your other loans. Your mortgage payments will increase, but the net impact on your cash flow will be positive once you pay off your other loans.
It’s important to remember that “secured” debt like mortgages and HELOCs are loans against your home. If you default on these loans, you could potentially lose your home. That is a very important risk to take into consideration.
If you don’t think you’ll be able to make your mortgage payments, it’s best not to refinance at this time.
If you don’t own your home or don’t have enough equity to refinance your mortgage, you can apply for an “unsecured” consolidation loan.
Since the loan is “unsecured” against other assets you have like your home, the interest rate will be higher than your mortgage.
An example of a consolidation loan
Let’s say you have $25,000 in credit card debt spread throughout three different cards.
Card 1 has a $5,000 balance at an 18.9% interest rate and a minimum payment of $130.
Card 2 has a $10,000 balance at 15% interest rate and a minimum payment of $338.
Card 3 has a $10,000 balance at a 20% interest rate and a minimum payment of $267.
That totals $25,000 in debt at an average interest rate of 18% with total minimum monthly payments of $735.
If you were able to refinance your mortgage and pay off the $25,000 in credit card debt, it would increase your mortgage payment by $132 per month. This assumes a 4% mortgage rate and a 25-year amortization period.
If you were able to consolidate all three credit cards onto a single consolidation loan with a 5-year term and an interest rate of 8%, your monthly payment would be $507.
In this example, consolidating your debt accomplishes three things.
You know when you will be debt-free.
The interest you pay on your debt has been significantly reduced.
You lowered your monthly payments by $603 in the case of a mortgage refinance and $228 per month in the case of the debt consolidation loan.
Point number three is what matters most. The lower you can get your monthly costs, the better your chances of riding out the recession.
The longer the amortization period on loan, the lower the monthly payment
Here is an important point to remember if you are considering a debt consolidation loan. The longer the term of the loan, the lower the monthly payment.
Let’s say instead of a 5-year term; you had a 10-year term on your debt consolidation loan.
That would cut your monthly payment to $303 per month. Saving you an additional $204 per month compared to a 5-year term and $432 per month compared to having three credit cards.
Yes, you will pay more interest if you take more time to pay off a loan. In normal economic conditions, we want to pay our debts as quickly as we can.
In a recession, our priorities change, and the name of the game is holding onto as much cash as possible until the economy recovers.
Everything has an opportunity cost. Increasing cash flow today by making only minimum payments or extending the term of a loan comes at the expense of paying more interest over the lifetime of a loan.
Make every penny count
If you are carrying a lot of consumer debt in a recession, it can be tempting to want to pay that debt down.
Remember, if you lose your job or fear you may lose your job, you have one priority during a recession; hang on to as much cash as you can.
Every dollar you put against your debt beyond the minimum payments is a dollar you don’t have to pay the mortgage or groceries.
If you can refinance your mortgage and pay off your consumer debt, that would free up the most cash every month.
If you don’t own a home or can’t refinance, you might consider a consolidation loan. Remember that the longer the term of the loan, the lower the monthly payment.
You’ll pay more interest in the long run, but remember the golden rule during a recession; hold on to as much cash as possible.
If you find yourself in a situation where you can’t consolidate your debt in any way or if the numbers don’t make sense, the best option would be to continue making the minimum payments on your loans.
Now is not the time to pay anything above the minimum required payment.
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This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.