Categories

Personal Finance

What Happens to Interest Rates During a Recession?

Interest rates tend to fall during a recession as countries' central banks lower rates in an effort to spur borrowing and economic growth. How the change impacts you will depend on a variety of factors, including how your personal finances have been impacted by the recession and whether you're trying to save or borrow money.

What Is a Recession?

When a recession occurs, there's often a widespread and lengthy decline in the economy. However, the exact measure and definition of a recession can vary.

One popular definition of a recession is when there are two consecutive quarters of negative gross domestic product (GDP) growth. But the nonprofit National Bureau of Economic Research (NBER), which determines the start and stop dates of recessions in the U.S., takes a more nuanced approach. In addition to looking at GDP data, the NBER considers other factors, such as income and unemployment rates.

In June, the NBER confirmed that the current U.S. recession began in February 2020. Once a low point is reached, the economy shifts from recession to expansion.

How Do Recessions Affect Interest Rates?

Interest rates tend to go down during a recession as governments take action to mitigate the decline in the economy and stimulate growth.

It can take several months to get all the data needed to determine when a recession starts, but the U.S. Federal Reserve cut its target interest rate in mid-March 2020 in response to the coronavirus outbreak's economic impact.

Low interest rates can stimulate growth by making it cheaper to borrow money, and less advantageous to save it. As a result, companies may borrow to invest in their business and individuals may look for ways to take advantage of low rates. For example, more people may be tempted to buy a new car with a low-rate auto loan, and the increased demand supports the activity that goes into manufacturing and selling the car.

However, you may find it's difficult to get approved for a loan during a recession, as creditors also become cautious about lending money. They may increase minimum credit score requirements, require higher down payments or even stop offering certain types of loans altogether.

Should I Refinance During a Recession?

If you can qualify for a new loan, refinancing your debts while interest rates are low could decrease your monthly payments and save you money. While there are pros and cons to each option, refinancing your mortgage, auto loan or student loans might be the smart move.

  • Refinancing mortgages: Due to the amount of money involved, refinancing a mortgage could lead to significant savings. However, you may need to pay closing costs on your new loan and prepayment penalties to your current lender. As a result, it could take several years to break even and benefit. Consider the cost and savings, and whether you're likely to stay in the home for long enough to make refinancing worth it.
  • Refinancing auto loans: Auto loan refinancing generally doesn't require closing costs, which can make it easier to determine if refinancing is a good idea. But still look out for prepayment penalties on your current auto loan or other fees that could eat into your potential savings.
  • Refinancing student loans: Student loans don't have prepayment penalties, and many private lenders don't charge origination fees. If you currently have private student loans and can refinance into a lower-rate loan, it may be a good idea. But refinancing federal student loans isn't as straightforward. You'll need to refinance with a private loan and will lose federal benefits, such as access to hardship options and forgiveness programs.

There are also some factors that apply to every type of debt. For instance, even if you get a lower interest rate and decrease your monthly payment, if you increase your repayment term, you may wind up paying more interest overall.

While refinancing is generally described as replacing a current loan with a new loan of the same type, you could also look into consolidating credit card debt with a personal loan while interest rates are low. Some personal loans have origination fees, but the loans may have much lower rates than credit cards and the fixed monthly payment can make it easier to stay on track and pay off the debt.

Check Your Credit Before Refinancing

If you're considering refinancing, or taking out a new loan, your credit can have a direct impact on your ability to qualify and the interest rate you'll receive. You can check your credit score for free with Experian, see which factors are impacting your score and learn how you may be able to increase it. Then, start shopping for a new loan to see which lender will offer you the best rate.

Resources