Finding The Next Best Place To Borrow
CNBC Senior Commodities Correspondent & Personal Finance Correspondent
The days of easy credit are probably over.
In an environment of falling home prices and tighter credit standards, some borrowers will have trouble borrowing money through a home equity loan or line of credit, as so many did in recent years.
Others will no longer even qualify for those loans, or have enough equity in their home to tap into for another loan.
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?
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. That’s easier said than done. Most cash-strapped Americans are in a position to do so. About 42% of households have less than $1000 in liquid assets (checking, savings, CDs, and stocks and bonds), according to SMR Research, a marketing research firm.
To Borrow Or Not To Borrow
Before you borrow any money, you need to ask several questions.
- Do you really need to the money? 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?Perhaps 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? Check out the payment calculator on www.bankrate.com . Calculate what you'd have to pay in the worst case. If interest rates or your plans change, you need to be prepared. “It’s imperative to project the financial impact,” says financial advisor Barry Glassman of Cassaday & Company in McLean, Virginia.
Where to Borrow?
“The best thing to do is avoid borrowing in the first place,” says certified financial advisor Stuart Ritter of T. Rowe Price. “But if you are going to borrow try to make sure you’re not undermining other goal, like retirement.” Pick sources that offer the lowest interest rates and pay back the loan as soon as possible.
- Friends or FamilyThe advantages of this method allow you to customize terms and come up with a repayment plan on your own, or get help from a company like VirginMoney, formerly CircleLending, ( www.virginmoneyus.com 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. On the downside, if you default on this loan, you could risk jeopardizing your relationship with a friend or family member.
Low-Rate Credit CardIf you're able to land a low-rate promotional offer -- say a teaser rate at 3% or better -- a credit card could make sense in a short-term crunch. Make sure you pay the balance in full before the introductory period ends. You have to be disciplined, set a repayment schedule and stick to it, says Greg McBride, senior financial analyst at Bankrate.com. Search for the lowest rate cards at www.interest.com or www.bankrate.com . But if you're already struggling with credit card debt, don't add to it by getting another card. “No sense digging the hole deeper,” McBride says.
- Retirement AccountsSome 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:
- Your 401(k)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% 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, says David Wray of the Profit Sharing/401(k) Council of America. There is typically a $50 loan initiation fee and an annual fee of $25 during the term of the loan.
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. 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 repayments you make are in after-tax dollars.
- Roth IRAYou can always withdraw contributions 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.)
- Traditional IRA-- The IRS doesn't permit loans. But if you need cash quickly and can pay it back quickly, 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.
Here’s the potential impact, according to calculations by T.Rowe Price’s Stuart Ritter. 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 his 401(k) than if he 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 loan had not been taken, given a 8% return on investments and a 7% interest rate on the loan.
The bottom line: If you’re in a hole, you have to stop digging, says financial advisor Barry Glassman. Borrowing may be only a temporary fix to a longer-term problem. You may not be able to make the purchases that you want or more drastic steps may have to be taken to change your lifestyle. Live within your means. Cut back on expenses until you're in the clear.
Editor's note: CNBC correspondent Sharon Epperson is the author of "The Big Payoff: Eight Steps Couples Can Take To Make The Most Of Their Money – And Live Richly Ever After" (Collins, $22.95).