Even if there isn’t a recession, “recession-proofing” your finances is an excellent way to strengthen them and ease the impact of any future hardship!
If you’re worried about a recession or just want to strengthen your finances, Laura covers seven steps to take now to ease the impact of a future hardship.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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Hey, friends! My name is Laura Adams, and I want to thank you for downloading the show and spending some time with me. If you're new here, I'm an award-winning personal finance author who’s been hosting Money Girl since 2008.
I'm also the author of several books, including Money-Smart Solopreneur–A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers. And I work with select brands as an on-camera PR spokesperson, consumer advocate, and multimedia creator.
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Since there’s been so much in the news lately about a potential recession, on top of rising inflation, stock market volatility, and interest rate hikes, this show will cover seven steps to protect your finances if you’re feeling uneasy about the economy.
Even if there isn’t a recession, “recession-proofing” your finances is an excellent way to strengthen them and ease the impact of any future hardship!
There are different definitions of a recession; however, most economists agree that it’s a period of declining economic performance that lasts at least several months. Since the 1940s, we’ve had a recession in the United States about every five years, and they typically last for less than a year.
So, while recessions aren’t good because they can cause wages to shrink, workers to get laid off, and stock prices to tumble, they’re a normal part of economic cycles. That said, we’re not officially in a recession, and I don’t believe one is coming in the short term.
Since we currently have a low unemployment rate, workers are earning money, and the labor market should remain strong. That makes it a perfect time to prepare your finances so you’re as resilient as possible for any unexpected challenges. If the pandemic has taught us anything, it’s that we don’t know what could be around the corner!
So, consider following the seven steps we’ll cover here to boost your financial wellbeing and give you more peace of mind!
The first step is to create a net worth statement.
If you’re feeling uneasy about your finances, the first place to start is genuinely assessing them. The best way to understand your financial health is to create a net worth statement, which I call a personal financial statement or PFS. It centralizes your entire financial life, so you clearly see your strengths and weaknesses.
You can create your PFS using paper, a software program, or a computer spreadsheet. Figuring out your net worth isn’t difficult; it just takes a little time to gather and accurately record all your information. You list and add up your assets and liabilities. When you subtract your total liabilities from your total assets, the resulting number (whether it’s positive or negative) is your net worth.
Assets are things you own that have value, such as real estate, cars, jewelry, electronics, cash in the bank, investments, and retirement accounts. Your liabilities are outstanding debts, such as mortgages, car loans, student loans, and credit cards. So if you have a home worth $400,000 and you owe $350,000 on your mortgage, you’d list the home’s market value as an asset and the mortgage balance as a liability.
It’s a good idea to update your PFS yearly and see if it’s higher, lower, or the same as last year. Higher net worth means you increased your assets, decreased debt, or both. However, if your net worth declines, make a goal to eliminate or reduce your debt.
The second step is to create a budget or spending plan.
After looking at the big picture of your finances by creating or updating your PFS, the next step is diving into the details of your cash flow by creating or reviewing your budget.
I prefer to call it a spending plan because it sounds less restrictive! It lists your sources of income, major expense categories, such as housing, food, insurance, and transportation, and goals, such as emergency savings and retirement account contributions.
You can create a spending plan manually on paper or a computer spreadsheet, but there are some terrific budgeting apps, such as Mint and Quicken, that automatically import your transactions. That makes it really easy to set and track your budget or spending plan each month.
The idea is to get familiar with your expenses, cut unnecessary costs, and allocate money to reach your goals. You may be surprised by how much you spend on goods and services you could live without.
For instance, do you really need an expensive gym membership or so many streaming services and subscription boxes? Could you shop local or online second-hand stores for pre-owned clothing, furniture, and household items?
If you’re living beyond your means or spending mindlessly, it’s time to correct those bad financial habits now, so you’ll be better off during any bad times down the road.
A good rule of thumb is to allocate 50% of your net (after-tax) income for essential expenses, such as housing, food, healthcare, insurance, and transportation. Limit your discretionary expenses, such as dining out and entertainment, to 30% of your income and the remaining 20% for savings—such as 10% for retirement contributions and 10% for building an emergency fund.
The third step to recession-proof your finances is to shore up your emergency fund.
Speaking of that emergency fund—how much cash do you have, and how long would it sustain you? Studies have shown that fewer than half of Americans could cover a $1,000 unexpected expense. If that’s you, or you’re starting from scratch, consider allocating more of your budget for a cash reserve, such as 15% instead of 10%.
While everyone should have a healthy emergency fund, it’s even more essential to have one during a recession. A good rule of thumb is to keep at least three to six months’ worth of living expenses in an FDIC-insured high-yield savings account. If you really want to be prepared, bump that amount based on your and your family’s needs.
Having enough money at your fingertips for emergencies should never be considered a luxury. Building a reserve should be a top priority, so you're never backed into a financial corner. Plus, it gives you peace of mind and can eliminate money stress.
Just make sure your cash stays safe and liquid. In other words, don’t invest your emergency money or lock it up in a bank certificate of deposit (CD) that would penalize you for access.
The fourth step is to pay down high-interest debt.
Once you’ve got a handle on your expenses and have emergency savings, take a hard look at your debt, especially accounts charging high interest, such as credit cards. Having fewer liabilities can take the pressure off if your pay gets cut or you lose your job or business income during an economic downturn. It can also be the key to living within your means if you tend to overspend.
If you need help creating a debt payoff plan, I created a detailed course for you called Get Out of Debt Fast--A Proven Plan to Stay Debt-Free Forever. It teaches multiple strategies to reduce and eliminate any debt you owe, such as credit cards, mortgages, and student loans. You can find a link in the show notes!
The fifth step to recession-proofing your finances is to have the right insurance.
A critical part of healthy finances is buying insurance to protect you from various financial risks. In addition to having money in the bank, it’s one of the best ways to protect your finances in uncertain times.
Here are some policies you may need or should carefully review if you already have them to ensure you have enough coverage.
Health insurance is essential for maintaining your physical and financial health, even if you’re young and healthy. A quick trip to the emergency room for an illness or a broken bone could leave you with a substantial medical bill.
Being uninsured and having a serious health condition could be financially devastating. Depending on your income and family size, you may be eligible for reduced premiums by shopping the federal or state marketplace at healthcare.gov.
Disability insurance is an often-overlooked financial safety net. According to the Council for Disability Awareness, one in four of today’s 20-year-olds will have an injury or illness causing a long-term absence from work before they retire. And when a long-term disability occurs, the average absence from work is more than two years.
A disability policy replaces a portion of your income, such as 60% or 70%, if you cannot work due to a covered accident, illness, or injury. It allows you to keep up with bills and meet your living expenses.
Remember that health insurance only pays a portion of covered medical expenses. It doesn't cover living expenses, such as housing, food, or debt payments if you can't work due to a health problem. That could cause a significant financial strain for you or your family members who depend on your income. So get as much coverage as an employer offers and supplement it when needed with an individual policy.
Life insurance is critical when your death would cause financial hardship for those you leave behind, such as a spouse, partner, or children. They can be set up as beneficiaries and receive a payout after your death.
If you're single or no one depends on your income, you either need a minimal policy for funeral expenses or none at all. If you have a stay-at-home spouse who cares for your children, you also need a policy on their life to cover future childcare costs.
Homeowners insurance is required by mortgage lenders to protect their financial interest in your property until it’s paid off. It pays claims to repair your home after a covered event, such as a fire, hail, or windstorm. Plus, it covers a certain amount of your personal belongings, such as furniture, electronics, clothes, and jewelry, and covers liability, if you get involved in a lawsuit.
If the market value of your home declines in a recession, be sure you aren’t overinsured. You should have enough coverage to rebuild your home after a disaster, but you don’t want to overpay if the market and building costs go down.
Renters insurance is an underutilized coverage because most renters don’t buy it. Note that your landlord doesn’t insure your possessions or liability, so having a renters policy is an excellent way to limit future risk. It’s also inexpensive, costing less than $200 annually on average across the U.S.
Remember that if you lose your job during a recession, any employer-provided insurance benefits typically end the next month, unless you opt for COBRA continuation for existing medical, dental, and vision plans.
The sixth step is to secure or increase your income.
If the economy goes downhill, one of the best ways to recession-proof your finances is to ensure your income remains as steady as possible. Are there ways to become indispensable at work so when an employer decides to downsize, you’re the person they can’t do without?
You might consider investing in your career. For instance, if you’ve always wanted to get an MBA or become a real estate agent, pursuing that education or a new skill set can make you more valuable in an economic downturn.
You could add an extra source of income now by starting and growing a side business. My latest book, Money-Smart Solopreneur–A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers, is an A to Z guide for anyone who wants to build a business and financial security.
Maintaining strong connections with others in your field could also set you up for success in a more competitive job market or help you find potential customers if you become self-employed.
The seventh and final step for recession-proofing your finances is to continue investing.
Once you have emergency savings and are adequately insured, making regular contributions to tax-advantaged retirement accounts at work or on your own is a surefire way to build wealth and simultaneously cut taxes.
When the economy goes south, many people stop investing for the future because they believe they can't afford it. While it's easy to get spooked by market volatility, it should never keep you from investing.
If you stop investing or cash out existing accounts when the financial markets dive, you lock in losses. In fact, when stock and fund prices go down, that's the exact time you should invest!
To maintain emotional objectivity, I recommend dollar-cost-averaging, which means investing a set amount each month or week, no matter if prices are increasing or decreasing—and selecting a diversified portfolio based on your age and goals. For young investors, that means mostly stock or growth funds, and for those approaching retirement, a split of cash, growth, and income funds limits risk.
Just be sure to never invest money in a retirement account that you might need for everyday expenses before the official retirement age of 59½. Taking early withdrawals typically comes with a 10% penalty in addition to income tax on amounts that weren’t previously taxed.
Related: 8 Pros and Cons of Investing in Crypto in Your 401(k)
Following these steps to prepare for a downturn when times are good will alleviate stress and worry about a potential recession. It’s always a good time to reevaluate your financial situation and improve what you can.
I’d love you to connect with me on Twitter @lauraadams or Instagram @lauradadams. And LauraDAdams.com is my personal site where you can use my contact page and learn more about my work, books, and money courses.
That's all for now. I'll talk to you next week. Until then, here's to living a richer life.