Are Personal Loans a Smart Move in a Recession? Here’s How to Decide

With a potential recession on the horizon, it’s worth asking whether a personal loan is your best option during an economic downturn. At first glance, this type of loan may seem like a particularly smart choice if the Fed decides to cut interest rates. However, taking on any debt comes with risk, and your decision to apply for a loan should only be made after fully assessing your risk tolerance and whether a loan fits your unique financial situation.

Pros and Cons of Taking Out Personal Loans During a Recession

Pros Explained

• Lower interest rates: During a recession, the costs of everyday goods and necessities rise, so people naturally spend less. To stimulate economic activity, the Federal Reserve typically cuts the Fed funds rate, which ultimately lowers the cost of lending. As a result, banks and other financial institutions are able to offer lower interest rates than they might otherwise.
• Debt consolidation opportunity: If you have multiple outstanding loans when a recession hits, taking out a new, larger one to consolidate them may be worth considering. Since interest rates are likely to drop, an economic downturn can be the perfect opportunity to streamline and possibly lower your monthly loan payments—potentially saving you a substantial amount in interest in the long run.

Cons Explained

• Job insecurity: On top of increased costs for everyday expenses straining your budget, recessions also tend to result in layoffs. If you take out a personal loan during an economic downturn and later lose your job, you’ll have incurred a debt that you no longer have the means to repay, which could put you in a substantially worse financial situation than before.
• Lack of loan availability: Financial institutions also have to navigate the financial hardships of a recession, and lower interest rates mean they stand to earn less from new loans. While some leaders may choose to continue lending, others may decide to reprioritize their efforts toward less risky and more profitable products.
• Stricter lending requirements: Lending during a recession is inherently risky, as borrowers are more likely to struggle with repaying their debts. To offset this heightened risk, lenders tend to tighten their lending standards. As such, borrowers may need to have better credit scores, lower debt-to-income (DTI) ratios, and cleaner credit reports to get a loan they might have more easily qualified for under better economic conditions.

Alternatives to Personal Loans During a Recession

Considering the risks that come with taking out a personal loan during a recession, you may want to consider one of these alternatives that are typically safer.

• Emergency savings: This won’t be a viable option for everyone, as you might lack sufficient savings to cover certain expenses. However, if you’re able to build a decent nest egg ahead of an economic downturn, then you’ll be able to avoid (or at least delay) needing to take out a personal loan just to afford necessities. Additionally, being able to even partially cover the cost of something will minimize how much you’ll have to pay back (and, by proxy, how much it’ll cost you in interest).
• Borrowing from friends and family: Instead of taking out a high-interest loan from a financial institution, you can ask a friend or family member to lend you whatever funds you require. Before accepting money from your loved ones, make sure all involved parties sign a written agreement that includes the terms of this loan. This way, you can head off any potential misunderstandings and/or strain on your relationship. This option might also be infeasible during a recession, as your friends and family may be struggling financially themselves, but there’s no harm in asking.
• 401(k) loans: Essentially tax-free and requiring no credit check, a short-term loan from your 401(k) account can allow you to secure the amount of money you need without taking on any actual debt. When you borrow from your 401(k), you’re essentially borrowing from yourself, as any interest paid goes into your account. As such, so long as the loan is repaid correctly, you stand to lose little to none of your retirement savings. A 401(k) loan is different from a 401(k) withdrawal, as with the latter you won’t get those funds back once they’re taken out, and the amount withdrawn will most likely be taxed.

The Bottom Line

Personal loans are normally a fairly safe way to borrow money, but this isn’t always true during an economic downturn. Being aware of your risk tolerance and fully understanding your financial situation can make all the difference between safely securing funding and taking on an unreasonable amount of debt. So be sure to review your finances and assess how much risk you’re willing to assume before you apply for a personal loan.