(This article is part of a weekly guest column by Claire Moylan*)
It’s certainly nasty out there in the lending world right now. As banks tighten their credit requirements, some people are wondering how to pay back large credit card debt or fund a down payment for a home. While many Americans haven’t been model savers in the short-term, many have retirement accounts that are a tempting source of money when times get tough. The amount of people borrowing from their 401K plans is increasing. It’s estimated that at least 20% of Fidelity’s clients are borrowing against their 401Ks. However, is this really a good option when money is tight?
Some Things To Consider
The reason people borrow from their 401K plans is because it’s easy to do. You just go to your employer and fill out some paperwork. In about a week, you have a loan to you from your own 401K account. The loan repayment can range from 1 to 5 years, sometimes 10 years, and is usually with a lower interest rate. Whatever interest you do pay when you repay the loan is returned to your account. So, the idea of borrowing from your 401K to reduce your debt burden elsewhere is very tempting. Even though there are limits to how much you can borrow (typically 50% of your vested interest up to $50,000), if you have a large retirement account and you aren’t anywhere near retirement, you may think putting the money towards paying down debt is a good strategy.
This might be the case, if it weren’t for one thing: You don’t know how secure your job is in this economy. If you are laid off, terminated, or even quit to get a better job before you pay off the loan, the entire balance is due in full – and, within 60 days of your leaving! If you do not pay the loan back within that amount of time, then you are subject to the same penalties and taxes as an early withdrawal. These are quite hefty and can result in a tax bill of up to 20 to 50% of the value of the loan; depending on what tax bracket you are in. So, taking a loan from your 401K is a risk if you leave your present job (for whatever reason) and can result in a large tax bill.
Other forms of loans that can help you in the event you need to get funds for a major purchase, like a home, or to repay a large amount of debt are: home equity loans, loans from credit unions or banks, or even a personal loan.
- Home equity loans – A home equity loan uses the equity in your home to help you consolidate your debt and pay it off. You can get some good rates on home equity loans and is a way of putting your equity to work for you, even while you still live in the home. Although this type of loan won’t come due if you lose your job, you do have to continue to make the monthly payments on time in order to keep your home. Since this is a risk with any home equity loan, you want to check to make sure that the terms of your agreement can be met and that you can afford the loan.
- Loans from banks and credit unions – If you belong to a credit union, they are very good for helping people lower the rates on their existing loans. Banks will have more market-competitive rates but are also a good source for lending, if you have good credit and some assets.
- Personal loans – Don’t overlook friends and families. You can even go to Prosper.com and get a personal loan from total strangers. If you want a loan to start a business or consolidate high interest debt and are having trouble with a bank, try to find someone who might know you who is willing to take on the risk based on your character. If you are paying 10% to someone else and they are willing to give you the loan at 7%, you are not only making a friend richer, but saving yourself some money too.
There are a number of creative ways to find financing, besides your 401K. Unless you are sure you intend to be at your job for the duration of the loan, or have funds to pay it back quickly, then it’s best not to tap this source.
About the author: Claire Moylan is a freelance writer specializing in ebooks and custom-tailored articles for niche websites. You can view her portfolio online or check out her constant content page for more information about her writing assignments.