By Christina Couch • Bankrate.com
As the economy slumps and unemployment rises, cash-strapped borrowers are looking for funds anywhere they can find them. However, don’t tap your 401(k) or other retirement plan when looking for cash.
“A 401(k) is money for your future,” says Earl McMahan, a Certified Financial Planner with United Advisors in Novi, Mich. “Don’t touch it. It’s sacred.”
A study by Watson Wyatt, a financial management consulting firm, shows that 27 percent of Americans took a hardship withdrawal from their 401(k) last year. While pulling 401(k) cash may solve a temporary problem, it can lead to larger ones at retirement time.
“The problem with 401(k) loans is that taking money out of a long-term account reduces its growth potential,” says Craig Skeels, managing director of Apex Wealth Management Group in Oxnard, Calif.
Fortunately, there are alternatives. Here are seven cash sources that won’t stifle future fiscal goals.
- Reduce bills
- Tap home equity
- Take out a reverse mortgage
- Get a personal loan
- Borrow against assets
- Tap into insurance
- Turn to family
Reduce bills
Instead of turning to loans, McMahan advises families to try to lower current bills. For example, a mortgage refinance might free up some extra cash, he says.
“You can also try raising your insurance deductibles,” he says. “If you know you can pay the money back relatively quickly, a credit card that doesn’t charge interest for the first few months might work.”
In addition to lowering home and credit card bills, families in temporary financial straits can create liquidity by deferring student loan payments. Borrowers can defer federal student loan payments for up to three years without affecting their credit scores, according to the U.S. Department of Education.
Tap home equity
Families in need of larger cash sums can tap home equity, says Greg Ward, senior resident financial planner with Financial Finesse, a financial education firm in Manhattan Beach, Calif.
A home equity loan or line of credit is usually cheaper than a 401(k) loan, Ward says. “Because you’re securing the loan with real estate collateral, you can get a loan in the 5 percent range with good credit. You’ll also have more time to pay it off,” he says.
On top of better loan terms, home equity transactions also offer tax incentives. According to the Internal Revenue Service, borrowers usually can deduct interest for the first $100,000 in loans or credit they take out. With the economy so shaky, Ward advises families who opt for home equity loans to pursue a fixed interest rate loan over a variable one.
“Rates are low right now, but that doesn’t mean they’re going to stay that way,” he says.
It’s important to note that many lenders have severely curtailed or completely eliminated home equity lending in the face of falling home values. So it may be more difficult to obtain this type of lending.
In addition, some borrowers who qualify for home equity lending may not qualify for interest rates below the rates for 401(k) loans, Ward says.
“Borrowers don’t have to go through a credit check with a 401(k) loan like they do to get a home equity loan,” he says. “For borrowers with really bad credit, a 401(k) loan may be a better bet.”
Take out a reverse mortgage
A second option for homeowners is a reverse mortgage, which allows a borrower to convert home equity into cash while continuing to live in the house. These products are available only to homeowners older than 62 who fully own their homes or have a small mortgage.
“Instead of borrowing from a bank, (reverse mortgage) borrowers pull money out of their home equity through a lender,” says Anthony Perrelli, an attorney and partner with Hedeker & Perrelli estate planning firm in Chicago. “They can either repay the loan with interest at the end or they can forget about it and when they die, the bank can take their house.”
For example, if someone owns a $400,000 home and needs $50,000 in cash, a reverse mortgage will provide the funds as a lump sum or a monthly cash payout.
The borrower can then pay the loan back and restore equity in the home or have the loan with accrued interest subtracted from the full value of the home upon death. Whoever inherits the home can then sell it, pay off the debt and take the leftover proceeds.
“Reverse mortgages also come with certain protections,” says McMahan. “Even if the value of the house goes below the value of the mortgage, nobody can make you move and after you die, the debt is forgiven for your children.”
While reverse mortgages can provide cash in an emergency, they come with pricey fees based on the value of the home rather than the value of the loan.
According to the U.S. Department of Housing and Urban Development, regardless of how much borrowers take out, they can expect to pay an origination fee of up to $6,000 (2 percent of the first $200,000 of the home’s value plus 1 percent for any equity over $200,000) and an insurance fee of up to 2 percent of the home’s value.
Borrowers are also responsible for paying closing costs, which may include appraisal, title search surveys, inspections, mortgage taxes and credit check costs, as well as monthly service fees of up to $35.
Get a personal loan
People who don’t have home equity but do have good credit may consider personal loans.
Available through banks and credit unions nationwide, personal loans are unsecured, meaning they don’t require collateral such as a car or home. Their interest rates and terms are largely based on the borrower’s income and credit history.
Skeels advises borrowers to start their loan hunt with banks, credit card companies and credit unions with which they have an established relationship. If they come up dry, borrowers may be able to woo lenders by offering a different asset as collateral, such as a paid-off car.
“You can get a used-car loan on your existing vehicle for maybe 50 percent of what they think the value is, and the interest rate would probably be 2 (percent) to 5 percent lower than if you got an unsecured (personal) loan from the same lender,” says Skeels.
Borrow against assets
People who own securities, futures or stock options can borrow against their portfolios in what are known as “margin loans.”
“With margin loans, you can usually borrow up to 50 percent of your portfolio at a rate that’s lower than unsecured loans,” says Ward.
Such borrowing can be risky, however. “It’s a double-edged sword,” says Ward. “If the securities you’re borrowing against go down, you have to either pay back the loan (with interest) or invest more assets to get your portfolio back up.”
Tap into insurance
Sometimes an insurance policy can be a source of quick cash.
For example, borrowers who have been paying on a whole life insurance policy typically can borrow against the money in their accounts at a rate under 5 percent, says Don Humphreys, president of Voyager Wealth Management in Harrington Park, N.J.
“You never have to pay it back,” Humphreys says. “Whatever you borrow will be subtracted from your death benefit, but you’re not required to repay it like you would a loan.”
Humphreys cites the example of a borrower who has built up a $50,000 account and wants to buy a $20,000 car for a grandchild.
“You can take that money out without paying it back, but now you only have a policy worth somewhere close to $30,000 for your beneficiary,” says Humphreys.
Those who repay must pay back the full loan sum plus interest to restore the insurance policy back to full value. Although policyholders can borrow up to 100 percent of the cash value of a policy, borrowers who drain their accounts without repayment are at risk of the amount of the loan (plus interest) one day exceeding the maximum cash value of the policy.
Should the loan grow that big, the borrower must pay the difference.
Turn to family
Before tapping a 401(k), McMahan encourages families to borrow from each other.
When doing so, it’s important to create mutually agreeable loan terms, put the transaction in writing and seal the deal with a witnessed promissory note, he says.
“Interfamily loans can work out marvelously for everyone, and they won’t deplete your retirement,” says McMahan.
Filed under: IRA's, Planning, Savings Strategies
