Last week Congress agreed to raise the debt ceiling, narrowly avoiding a first ever default in U.S. history. While the crisis has been averted for now, the deal only buys us around two more years before we’re facing the same risk of the government defaulting on its debt.
A government default would mean stock prices plummet, consumer prices spike, and jobs are lost. As an individual consumer, so much is outside your control: What steps can you actually take to best protect yourself against a possible government default or shutdown? Here’s how to prepare your personal finances now.
When it comes to big purchases, act now...
...Or forever hold your peace. One of the major consequences surrounding a default is soaring interest rates. This impacts everything from your mortgage, to your student loans, to your credit card.
For instance, real estate website Zillow estimates that in the fallout from a default, mortgage rates could reach a whopping 8.4%. So if you’re closing on a home, act now and make sure your interest rate is locked in.
Tackle high-interest debt now
Simply put, there are two main approaches to tackling debt: the debt snowball, and the debt avalanche. The snowball method targets your smallest debt first, no matter the interest rate, while the avalanche prioritizes debts with the highest interest rates. When it comes to looming economic hardship, the debt avalanche is the way to go.
To use the debt avalanche strategy, Nerd Wallet recommends adding up all the minimums you must pay on your debt (excluding your mortgage). Order them from highest interest rates to lowest; Smith says that any interest rates over 5-7% should be your priority. Then, make a budget to determine the maximum amount you can afford to put toward paying off your debt each month.
Create a financial cushion
No matter the state of the economy, it’s a wise move to build a solid emergency fund. As we’ve previously advised, the typical rule of thumb is to aim for six months’ worth of living expenses in your emergency fund. Although given the state of inflation, you might consider raising that target to have nine months’ worth of take-home income stashed away.
Having that big a safety cushion may seem excessive, but it’s easy to underestimate how much money you’ll need in case of an emergency. One tactic is to first establish a “starter” rainy day fund of around one month of rent or mortgage payment, plus your insurance deductible. After you hit that amount, refocus on paying off high-interest debt. Then you can resume building an emergency fund that can cover you for six months or longer.
The bottom line: Don’t panic, but do prepare
You should prepare for a default as you would prepare for any recession or other sort of economic uncertainty. In addition to the tips above, remember that when we live in fear, we make worse financial decisions. All you can do is focus on what you can and cannot control. That means focusing on action items like cutting back on your spending, building your emergency fund, and otherwise steeling yourself for default-related effects (like job loss, higher inflation, and more expensive loans). Make the most of the next few years and protect your finances now, before the country gets dangerously close to hitting the debt ceiling again.
