Financial risk areas to watch before a possible recession

FILE - A sign is displayed on the floor of the New York Stock Exchange in New York, Wednesday, June 14, 2023. Halfway into 2023, and so little on Wall Street has gone according to plan. The S&P 500 has climbed roughly 14% as one of the most-predicted and longest awaited recessions in history has yet to appear. (AP Photo/Seth Wenig, File)(AP/Seth Wenig)

The high rate of inflation and skyrocketing interest rates have caused many Americans to fear a recession is around the corner. While we haven’t entered that period yet, it’s always a good idea to make sure you are financially secure in times of uncertainty.

Recessions are accompanied by specific financial risk areas — such as rising debt balances, an increase in defaults and job loss — that you can protect against with a solid emergency fund and other tools.

[MORE: Recession Odds Recede on Good Econ Data]

3 Financial Signs That Point to Recession Risk

By definition, a recession is an extended period of economic downturn, typically noted by two consecutive quarters of negative gross domestic product growth, says Kyle Enright, president of Achieve Lending in San Mateo, California.

But there are typically other financial signs that precede an official recession, he adds.

On a macro level, rising unemployment levels, rising debt (both secured and unsecured, though credit card debt — a type of unsecured debt — is one indicator experts closely watch) and vehicle loan late payments and defaults are areas experts watch, says Enright.

Here are three signs that might indicate a recession is on the horizon:

1. Rising Unemployment

Unsurprisingly, an increase in unemployment is often a precursor to and part of a recession. When people lose their jobs, they can’t spend as much on goods and services, which negatively impacts the economy.

As of May 2023, the U.S. Bureau of Labor Statistics reported the unemployment rate at 3.7%, an increase of 0.3% from the previous month. The Federal Reservepredicts this rate will continue to grow through the end of the year.

Still, the rate is much lower than pandemic-era highs in 2020 and 2021.

2. Rising Debt

“Accumulating debt and inability to make payments of any kind are key warning signs of a recession,” says Enright.

Whether we’re talking about rising credit card or other kinds of loan balances, debt increasing is a sign that Americans are struggling to pay their bills and have to borrow more, which could lead to economic impacts.

Debt is indeed on the rise — the latest Federal Reserve Consumer Credit report, released June 7, 2023, shows revolving credit increased at an annual rate of 13.1% in April and nonrevolving credit at a rate of 3.2%.

[READ: What to Do When You’re Deep in Debt.]

This debt affects consumer spending as well.

“In March, results from a study Achieve conducted showed that 35% of Americans were planning on or already had to spend cash from their emergency savings. More than a quarter (26%) had considered or were in the process of missing a payment or paying less than what’s required on their credit cards, loans or other debt,” says Enright.

3. Loan Defaults

Like rising debt, defaulting on loan payments is another financial risk factor for recession. It’s a signal that debt has gotten out of hand and many are unable to make even minimum payments, facing consequences ranging from credit score impact to wage garnishment.

Unfortunately, delinquency rates on loans are also on the rise, per the Fed — across both credit cards and other loan types. As of the first quarter of 2023, the delinquency rate across consumer loans was 2.23%, the highest it has been since 2020.

How to Prepare Your Finances for a Possible Recession

These financial risks are certainly scary, but with the right preparation, you can minimize the impact of a recession on your own finances.

“Recessions come in different flavors. Most people will remember the short 2020 recession or the deep 2008 recession. Those least affected by them were the ones that maintained a suitable level of liquidity and savings. This ’emergency fund’ or ‘safety cushion’ requires discipline during the prerecession run-up and instant gratification economy,” says Brad Tedrick, certified financial planner and president of Vantedge Wealth Management in Carlsbad, California.

[READ: Good Reasons to Spend Money from Your Emergency Fund]

Follow these tips to build a safety cushion ahead of a possible recession:

Hold yourself to a budget. A budget is a key financial tool in the best of times, and it’s even more critical when money is tight. According to Enright, it’s a good idea to check in on your spending plan and identify any potential vulnerabilities so you can prepare for adjustments.

Pay down debts. “Make a plan to pay off credit card debt. This is one of the best financial cushions you can create,” says Enright. With interest rates rising, carrying a credit card balance is already expensive, but if you lose your job, making payments becomes even more difficult. If possible, prioritize paying down your debts now so you don’t have to worry about them down the line.

Build your emergency fund. Emergency funds are specifically designed to help weather financial storms like recessions, so when you expect one is coming, that means it’s time to add to it. “In recessionary times, income stability could be threatened, from a complete job loss to reduced hours or pay. The best thing you can do now is to shore up savings,” says Enright.

Adjust your investment plan. If recession hits, the national and global economy will both be affected, which can impact your investments and retirement savings. Tedrick recommends taking a close look at your investment portfolios and making adjustments based on risk before a recession.

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