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.
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.
More Stories From Bankrate.com:
- How to Plan for Retirement
- Asset Allocation Explainer
- How to Tell if Your Retirement Plans are on Track
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.
"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."