What Happens to Interest Rates During a Recession?

What Is a Recession?

A recession is a widespread and lengthy decline in the economy. However, economists disagree on exactly how to define a recession.

For example, one popular definition is when there are two consecutive quarters of negative gross domestic product (GDP) growth. However, 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, consumer expenditures and unemployment rates.

How Do Recessions Affect Interest Rates?

Interest rates tend to go down during a recession, primarily due to government action to stimulate the economy.

Consumer spending is a significant driver of economic growth, but during a recession, when the job market is shaky and income growth is stagnant, consumers often reduce their household expenses. That leads to lower demand for consumer loans.

One of the functions of the Federal Reserve is to promote healthy economic growth, and one of the levers it uses to do that is raising and lowering its federal funds rate—the rate at which banks lend to each other on an overnight basis.

During a recession, the Fed often lowers its federal funds rate, which leads banks and other lenders to offer lower interest rates on consumer loans. Lower rates can help spur borrowing, leading to increased consumer spending and economic growth.

For example, during and following the Great Recession and the short-lived recession caused by the coronavirus pandemic, the effective federal funds rate was near zero.

It's important to keep in mind, though, that interest rates will only go down for variable-rate loans and new loans. Existing fixed-rate loans won't be affected, though there may be opportunities to refinance.

Should I Take Out a New Loan During a Recession?

Taking out a loan during an economic downturn can be risky, but depending on your situation, it could be worth it. Whether you're thinking about a mortgage loan, auto loan or personal loan, interest rates may be attractive.

That said, here are some things to consider before you decide to borrow:

• Credit score: During a recession, lenders often tighten credit standards, making it harder to get approved. In other words, it's even more important that you have stellar credit. Check your credit report and FICO^® Score^Θ for free from Experian to get a feel for where you stand and whether you need to improve your credit score before moving forward.
• Budget: You'll want to make sure you can comfortably afford to keep up with your debt payments without sacrificing other important financial goals.
• Savings: It's always a good idea to maintain a robust emergency fund, but it's even more important during a recession. Having some good financial padding may give you more confidence to take on new debt.
• Job stability: Having a stable income situation makes it easier to assess your ability to repay any debt you incur. If you're concerned about losing your job or potentially having your income slashed, now might not be the right time to borrow money.
• Reason for borrowing: You may want to avoid borrowing money for unnecessary reasons, such as taking a vacation or buying holiday gifts. However, it could make sense to borrow to consolidate high-interest debt, make repairs or improvements to your home, buy a new home or attend college.
• Borrowing costs: In addition to interest rates, you'll also want to consider other expenses, such as closing costs, origination fees and more.

Should I Refinance During a Recession?

Depending on your situation, a recession could create an opportunity for you to refinance existing debts, particularly if market rates are lower than what you're currently paying. Here are a few things to keep in mind as you determine whether or not refinancing is right for you:

• Credit score: As previously mentioned, it can be harder to get approved for credit during an economic downturn. Monitor your credit and consider whether you need to take steps to increase your credit score before you try to refinance.
• Closing costs: Some loans, particularly mortgage loans, can come with hefty closing costs that you may need to pay upfront. In some cases, it could take years to break even with the monthly savings of a lower payment. So, it's important to compare potential costs and savings to determine if it's worth it.
• Prepayment penalties: Some loans may also come with prepayment penalties that you'll incur if you refinance or pay off your loan too early.
• Lost benefits: If you have federal student loans, you may be tempted by low refinance rates. However, it's important to keep in mind that you'll lose access to federal loan benefits, such as forgiveness and income-driven repayment plans, if you move your debt to a private lender.
• Repayment terms: 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.

The Bottom Line

While a recession can create opportunities to borrow or refinance at lower interest rates, it's important to proceed carefully. Your financial stability, credit health and long-term goals should guide your decision.

Take time to weigh the benefits of lower borrowing costs against the risks of adding new debt during a period of economic uncertainty. Whether you choose to borrow, refinance or stay the course, understanding how interest rates behave in a recession can help you make more informed, confident financial choices.