BLOG

How Payments Fare During Economic Growth Versus During a Recession

Loan payments of all types fare very differently during periods of economic growth than they do during periods of recession. The reason is simple. Businesses or consumers make loan payments, and because of a strong economy, they are more likely to make them without difficulty.

temp-post-image

Economic Growth Is a Loan Payment’s Friend

In periods of economic growth, a business is very likely to be doing well. Sales and profits may rise. A business may thus have plenty of money with which to pay loan payments. Consumers are also likely to do well when the economy is growing. They are more likely to receive raises and promotions at robustly growing companies. They may find it easier to move to companies that pay better. In addition, consumers will have more disposable income in which to make loan payments.

There are several risks in payments during an expanding and strong economy, however. Both businesses and consumers make take out loans when times are flush expecting to have no problem paying them back. Businesses may take out business loans and consumers take out mortgage, personal, car, and student loans. A contracting economy may make the picture look very different, however.

If loans are opened in a recovery period, while the economy is heating up but still hasn’t fully hit its stride, interest rates may still be on the low side. In an effort to curb inflation, the U.S. Federal Open Market Committee (FOMC) will raise interest rates as the economy goes into full throttle. If loans are low interest, payments can be very reasonable.

But, if the loans they take out have a variable interest rate, climbing interest rates can make the loan service burden much higher. Both businesses and consumers may start to experience difficulty in making payments if this happens.

temp-post-image

Recessions Pose a Risk of Delinquent Payments and Default

Just as economic growth makes it very possible for businesses and consumers to make loan payments on time — and even to prepay them — a recession increases the risk of loan payments becoming delinquent and even going into default.

A recession is characterized by two or more quarters of negative economic growth. They are usually precipitated by a crisis, such as a stock market crash or stagnant growth. When recessions start, businesses stop expanding and they are likely to experience falling sales. They might start laying people off as a result, or dropping expansion plans.

Consumers who are laid off and businesses no longer getting orders from other businesses contract even further. Both spend less, increasing the cycle of contraction.

Consumers and businesses who are in a recessionary environment can become strapped for money. They may elect to use money set aside for loan payments for needs they consider more pressing. A business may use loan payment money for cash flow to keep going rather than loan payments. A consumer may have more pressing needs for food and transportation and may start skipping loan payments.

Delinquencies and defaults rise as a result.

Homes may go into foreclosure and other types of loans into collection, as banks and other lending institutions try to make good their loans.

Bank loan originations can fall during this period. However, the FOMC usually reduces interest rates in recessions, so that money becomes easier to borrow for business expansion. Business expansion is a mechanism to pull the economy into recovery. Dropping rates can, of course, make loans more affordable for both businesses and consumers, so loan originations may start to rise again.

What the Future Holds for Loan Growth

Right now, the U.S. economy is strong. However, as recent sharp declines in the stock market show, crises can happen unexpectedly, and with them, economic shocks.

Banks should be savvy risk managers of their portfolios, so that delinquencies and defaults as a result of missed payments don’t occur.

To discuss economic cycles and the effect on banks further, contact us.