How Your Credit Changes During A Recession
A recession creates financial tensions across all aspects of the economy. A spike in unemployment, disappointing stock market performance, slower economic activity, and tiger lending practices from financial institutions.
Most U.S. households have experienced the ripple effects of such events, and how it can create challenges for personal finance, including . In the aftermath of the Financial Crisis between 2008 and 2009, approximately 50 million Americans saw a 20 point or more decline in their FICO 8 Scores. From the same cohort, two-fifths saw their score decline by more than 50 points.
Following the pandemic-related economic slowdown, 42% of U.S. consumers had increased taking on more debt and increased account utilization to cover ordinary expenses. However, data by the Federal Reserve Bank of St. Louis indicates that on the other end of a recession, some individuals may see their scores improve, as witnessed in the aftermath of the pandemic.
The Reality Of Economic Hardships
An economic downturn can significantly impact household finances. Understanding the key challenges can help a person anticipate potential financial obstacles and implement steps to help safeguard financial stability during tough times.
- Increased Risk of Missed Payments
During an economic downturn, many people face job loss, reduction in wages or reduced income. This financial strain may lead to an increase in missed payments on bank accounts, loans, or utilities. Since payment history accounts for 35% of your score, even one late payment can result in a significant dip.
- A Higher Utilization Ratio
Economic uncertainty may force households and individuals to rely on cards for essential expenses. However, as your card balances rise relative to your limit, your utilization ratio—which accounts for 30% of your score—increases. A higher ratio can negatively impact your score..
- Reduction in Limits
Lenders may respond to economic challenges by reducing available limits to mitigate risk. Even if your spending habits remain unchanged, you may be subject to a lower limit availability, and increase the utilization ratio, and potentially impact your score.
- Limited Access to New
During economic decline, lenders often tighten their approval criteria, making it more difficult for consumers to obtain new . This can restrict your ability to consolidate debt or secure loans during emergencies.
Experts are not divided on the matter. When asked, Matt Mayerle, Personal Finance Editor at CreditNinja, says, “During poor economic conditions, households might experience job loss or reduced income. In some instances, this may lead to higher utilization or missed payments on their accounts.” He continues, “Navigating these challenges are tough, but it’s important to have a proactive management strategy to help protect your household finances.”
Risk of Economic Downturns On Demographic Groups
The impact of economic downturns on personal finance is not uniform; different demographics experience varying degrees of financial strain.
- Young individuals: The COVID-19 pandemic sent the global economy tumbling, and younger demographics, specifically young workers and recent graduates were most hindered by the downturn of the economy.
Unemployment rates among young American workers ages 16-24-years rose from 8.4% to 24.4% from spring 2019 to spring 2020. The unemployment rate for their counterparts, ages 35 and older made a similar jump, and rose from 2.8% to 11.3%.
Furthermore, the Pew Research Center found that sixty-one percent of adults aged younger than 30-years said that they or someone in their household had experienced job or wage loss during the outbreak of the pandemic while the U.S. economy was in a free fall.
Limited financial opportunities at the time of an economic slump impacts younger demographics far more severely compared to their older counterparts. In return, we often see more young people relying on financial support from friends or family, or perhaps increasing their utilization ratio and near-term debt burden.
- Middle-aged individuals: Compared to younger demographics, more established individuals that balance mortgages, auto loans and family-related expenses may face a mix of unique challenges during periods of economic downturns.
In one study, researchers found that a local pandemic had a strong negative effect on account spending during the early months of the pandemic, however this declined over time. Furthermore, severity of the pandemic has a negative effect on card repayments. The sudden loss of income may lead to missed payments, defaults or limited access to new debt.
However, this demographic may have a better sense of creating a financial safety net following the collapse of the stock market and the global economy during the 2007/08 financial crisis.
- Retirees: Slower economic progress may create obstacles for would-be retirees and those already in retirement. Falling market performance could lower retirement savings, which might see more retirees relying on fixed incomes that can leave minimal room to manage unexpected expenses.
In a poll by the Employee Benefit Research Institute about 68 percent of retirees were said to have above-average card debt in 2024. This was a substantial increase from 40 percent in 2022, and 43 percent in 2020, during the pandemic. For this demographic, relying on credit for medical bills or living expenses can increase debt-to-income ratios, posing a threat to financial stability.
Mayerle advises, “Economic downturns impact people differently depending on their financial stage in life. Younger individuals may struggle with building up their financial history due to limited income, while middle-aged adults balancing loans and family expenses face higher risks of missed payments. Recognizing these unique challenges can help tailor solutions for each group.”
How The Stock Market Performs During A Recession
Macroeconomic shocks can upend markets, leading to an overall decline in corporate earnings, and result in slower expansion of market opportunities and stock performance delivery.
- Sinking Investor Sentiment: Investors tend to share a less optimistic outlook regarding the stock market due to a sharp decline in corporate earnings, reduced company profitability, and slower growth.
- Price Plunge: A sharp, and heavy decline of stock prices is another indication of a tightening economic situation. In many instances, investors may engage in erratic selling, which in return causes stock prices to plunge.
- High Volatility: In finance, volatility is seen as the rate at which a stock price increases or decreases, and in an economic slowdown, volatility becomes a cornerstone of the stock market, pushing stock prices to extreme lows, and causing daily price swings.
- Increased demand for safer options: Though stock declines are cyclical, investors tend to migrate towards safer investment alternatives, including government bonds, and money markets of cash.
- Reduced portfolio value: A reduction in stock prices and performance tends to lead to an overall decline in portfolio value i.e. return on equity. For this, it’s important to remember that diversification can help to mitigate near-term risks and volatile price swings.
How To Weather The Storm
For investors and households it’s important to maintain good financial habits, and adopt proactive strategies to remain financially resilient.
Households and Individuals
Create a Budget and Prioritize Essentials
Start by assessing your income and expenses. Prioritize essential bills such as housing, utilities, and minimum debt payments. A detailed budget can help you allocate funds effectively and avoid unnecessary spending.
Communicate with Lenders
If you anticipate difficulty making payments, contact your lenders as early as possible. Many financial institutions offer hardship programs, including deferred payments or reduced interest rates, to assist customers during economic downturns.
Monitor Your Account Report
Frequently review your account report to identify any inaccuracies or signs of fraud. Each of the three major bureaus provides one free report per year. Resolving any errors quickly can help maintain financial stability.
Keep Your Account Utilization Low
Even during tough times, aim to keep your utilization below 30%. If possible, make extra payments on your card balances or request a limit increase to improve your ratio.
Avoid Closing Accounts
Closing an account may seem like a good idea, but it can reduce availability and increase your utilization ratio. Additionally, keeping older accounts open and active will help drive a more positive impact for your overall score.
Explore Alternative Options
If you need funds during a downturn, consider installment loans or lines of with manageable repayment terms. Research options thoroughly and understand the terms to avoid predatory lenders.
Mayerle explains, “Protecting your score during an economic downturn starts with communication and planning. Reach out to ors early if you anticipate difficulty making payments, and explore options like hardship programs or deferred payments. Proactive steps like budgeting and monitoring your account report can make a significant difference in maintaining your financial health.”
Investors
Diversify Investments and Rebalance Portfolio Holdings
As an investor, it’s important to have a clear understanding of how to diversify your portfolio, even before a market turndown takes place. Having a proper balance between equities, bonds, and other investment instruments will help you weather the storm more effectively.
Be Considerate of Equity Holdings
Part of the rebalancing should include choosing equity options that will provide more buoyancy during a sharp market decline. For instance, defense stocks i.e. health care and defence stocks tend to provide more resilience compared to consumer-focused options.
Try to Remain Agile
Be prepared to make some changes to how you approach the market and select investments. Consider adjusting your investment strategy to accommodate the changing landscape.
Undertake a More Long-Term Outlook
You may be tempted to pull out of the market, but it’s important to maintain a more long-term outlook and consider how conditions will eventually change. On average, a recession will last between 10 to 18 months.
Hold Onto Cash Reserves
Having a portion of your portfolio in cash or cash derivatives will provide you with more flexibility. By holding onto cash, you will increase your liquidity and have more leverage to purchase assets offered at reduced prices.
Building Resilience for Future Economic Challenges
Economic downturns are inevitable, but the long-term impact can be mitigated through preparation and strategic planning. By building financial resilience, you can better navigate future challenges and protect your financial health.
- Focus on Financial Literacy
Understanding personal finance concepts such as budgeting, and debt management, can empower you to make informed decisions. For example, learning about score charts can help you understand where you stand and what actions to take to improve your situation.
- Establish an Emergency Fund
An emergency fund can act as a financial cushion during periods of uncertainty. Aim to save three to six months’ worth of living expenses to reduce reliance on making new debt during economic downturns.
- Diversify Your Income Streams
Consider taking on freelance work, part-time jobs, or passive income opportunities to supplement your primary income. Additional income can provide a buffer against financial instability.
Preserving Stability
You can mitigate the impact of economic downturns with proactive measures. By understanding how these periods affect your score and implementing strategies to protect it, you can confidently navigate financial uncertainty.
However, recessionary instances can quickly change the course of direction for any person. Improper planning, and applying ineffective financial strategies can hamper your ability to keep head above water during economic downturns.
Protecting personal finances amid macroeconomic shocks means taking proactive measures to ensure your long-term financial sustainability is not severely impacted. As an investor, or individual, remain agile, and keep in mind that a recession could happen at any moment, exposing you to more financial risks, and can be hard to navigate during economic recovery.