Over the past few years, many borrowers took out home equity loans to finance everything from home improvements to college education. In an environment of falling home prices and tighter credit standards, some borrowers will have a tougher time borrowing money through a home equity loan or line of credit. Some people will no longer even qualify for those loans, or have enough equity to tap into. So where's the next best place to borrow money? Is borrowing from your 401(k) better than racking up more credit card debt? Where should you go to borrow money now? CNBC correspondent Sharon Epperson lists where to go when you're strapped for cash:
Tap emergency savings
Your best bet is to tap your own short-term savings. Ideally, you should have an emergency reserve of three to six months of living expenses in a high-yielding savings account. Easier said than done. Most cash-strapped Americans have little money saved that they can access easily. About 42 percent of households have less than $1,000 in liquid assets (checking, savings, CDs, and stocks and bonds), according to SMR Research, a marketing research firm.
Do you really need the loan?
Really ask yourself if you need to borrow the money at this time. Can you wait to purchase that new car or make a home improvement? And remember, you can borrow money for a new car, but not for retirement. Only raid your nest egg as a last resort.
Is there an alternative?
If you're concerned about increasing mortgage payments because your adjustable rate mortgage is about to reset, is there a way that you can work out a payment plan for your mortgage or credit cards so that you don't have to rack up more debt?
Can you afford the payments?
Make sure you can afford the payments — check out payment calculators on www.bankrate.com, for example. Calculate what you'd have to pay in the worst case. If interest rates change or your plans change, you need to be prepared.
Here are some loan choices, in descending order:
Friends or family
First choice: Borrow money from a family member or friend. You can customize terms and come up with a repayment plan on your own. Or, get help from a company like VirginMoney (www.virginmoneyus.com, formerly CircleLending) that specializes in setting up family loans. For $100 they'll help you set up the terms of the loan, put it in writing, and take some the emotion out of it. Downside: If you default on this loan, you could risk jeopardizing your relationship with a friend or family member.
A low-rate credit card
If you're able to land a low-rate promotional offer, a credit card could make sense in a short-term crunch. If you're disciplined, set a repayment schedule and stick to it. But if you're already struggling with credit card debt, don't add to it by getting another card. Search for the lowest-rate cards at www.interest.com or www.bankrate.com.
Some 401(k) plan providers are seeing a noticeable rise in consumer borrowing from their 401(k) accounts — raiding the money they'll need for their retirement. Borrowing money from one of your retirement accounts is generally a bad idea and can compound a short-term problem with long-term detrimental effects. Here's why:
Borrowing from your 401(k)
Upside: Most 401(k) plans let you take money out and repay it, plus interest, usually 1-2 points above the prime rate (about 8.5%-9.5% right now). Plans vary, but usually the maximum loan amount is 50 percent of the balance or $50,000, whichever is lower. You generally have to pay back the money within five years, and usually a payroll deduction repayment is required. There is typically a $50 loan initiation fee, and an annual fee of $25 during the term of the loan.
Downside: There are some major pitfalls in taking a 401(k) loan. If you don't pay back the loan on time and you're under 59 ½ years old, you're subject to regular federal and state income tax and IRS penalty tax of 10% for early withdrawal. If you're laid off or quit your job, the loan must be paid off within 90 days, but it could be due immediately.
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Even if you pay the money back, you lose out on the tax advantages and the compound interest on the money had it been invested. Money that you put into a 401(k) is pre-tax, the payments you make are in after-tax dollars.
Potential impact: Someone who has amassed $30,000 balance at age 35 takes a $10,000 loan and stops making contributions to pay back the loan over the next five years. Even if the loan is repaid in five years, at 40, that person would have $19,748 less money in their 401(k) than if they had not taken the loan and had continued monthly contributions. But when it really counts at age 65, there would be nearly $145,000 less money in the plan than if the loan had not been taken, given a 8% return on investments and a 7% interest rate on the loan.
Borrowing from a Roth IRA
Upside: Withdraw contributions without tax or penalty
Downside: Lose earning power
You can always withdraw contributions to a Roth IRA without taxes or a penalty. That's contributions, not earnings. But you are permanently retarding your retirement savings. You'll lose the earning power of your money over time. Plus, there is no way to get that money back in the account once the crisis passes. Future contributions are limited by the annual contribution limits. For 2007, you can contribute up to $4,000 in a Roth or traditional IRA ($5,000 if you're age 50 or older.)
Borrowing from a traditional IRA
Upside: One 60-day tax-free withdrawal per year
Downside: After 60 days pay tax and 10% withdrawal
The IRS doesn't permit loans from a traditional IRA. But if you need cash quickly and can pay it back fast, you can withdraw funds from your IRA for up to 60 days tax-free. Funds must be replaced in 60 days or you wind up paying income tax and a 10% early withdrawal penalty. A withdrawal can be made just once a year.
Bottom line: Live within your means. Cut back, tough love, until you're in the clear.
CNBC personal finance correspondent Sharon Epperson is the author of “The Big Payoff: 8 Steps Couples Can Take to Make the Most of Their Money — and Live Richly Ever After" (HarperCollins).
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