Posted: May 2nd, 2011 | Author: Joe | Filed under: Debt, Tips | Tags: 401(k) loans, Debt, SmartMoney | 4 Comments »
Here’s a great example of how “smart” money people often get lost in the details, and make bad choices (or in this case, bad recommendations to people). I’m talking about a recent SmartMoney article where they espouse the virtues of borrowing from your 401k.
The basis for their recommendation that “never borrow from your 401k” is outdated financial advice is that they believe a 401k loan is:
“The most affordable loan available.”
This is true – up to a point. They’re mostly just looking at interest payments, and ignoring all the other effects and risks of a 401k loan. When you simply examine the interest owed and compare that to other loans, then a 401k loan does seem like a clear winner.
According to the Profit Sharing/401(k) Council of America:
“Approximately 90% of employers offering 401(k)s permit employees to borrow from them, according to the PSCA, and the loans can last for up to 15 years.”
But just because you can do it, doesn’t mean borrowing from your 401k is a good idea.
Let’s look at this a little deeper..
Why borrowing from a 401k is a good idea (sort of)
The pundits at SmartMoney would have you believe that borrowing from your 401k is a smart money move, at least in the current economic climate. But does this really make sense beyond the simple comparison of interest paid after taxes?
Here’s SmartMoney’s spin:
“Advisers, for example, typically discouraged clients from taking a loan from their 401(k) – but this is now the cheapest way to borrow money, with the average rate at 4.25%, lower than most personal loans”
Their cursory comparison of interest breaks down like so:
- Average credit cards interest rate: 14%
- Average home equity lines of credit interest rate: 5.22%
- Average 401k loan interest rate: 4.25% (“prime (currently 3.25%) plus 1%, “)
Some of their other arguments in favor of borrowing from your 401k are:
- The money you pay the loan back with goes into your 401k, instead of to a bank.
- Paying a 401k loan off is easier than other loans, because the contribution you would normally be making go toward the loan 1st.
Why a 401k loan is a bad idea
OK, so by those numbers, a 401k loan doesn’t seem so bad. But here are some things not considered:
- Time stops working with you, and starts working against you. When you stop saving for retirement, you put that day you can retire further off in the future – lengthening the time you’ll need to work.
- Increased taxes. You end up owing more in taxes due to the lost deduction when you stop contributing to the plan to pay off debts and other loans.
- Decreased gains. You lose much of the gains in your 401k because you have less money “at work” compounding gains for you.
- The entire loan amount will become due within 90 days should you leave your job or lose your job. Failure to pay that amount results in the outstanding balance being treated as taxable income and you get hit with an additional 10% early withdrawal penalty if you’re younger than 59 1/2.
- Welcome to servitude. Besides the very real risk of losing your job in a high unemployment environment, this is in effect making you even more of an indentured servant to your employer as you lose a significant amount of job flexibility. You will not be able to take a new opportunity at another company without a financial penalty (see above) if you cannot pay back your 401k loan in full first. Think about that.
Final thoughts
Well by now you can tell I’m no fan of 401k loans, but like so many things in finance there is no hard-fast rule here. Borrowing from a 401k may make sense for some people in dire straights, but even considering such a move should be viewed as a sign that you’re on shaky financial footing.
To me, a 401k loan is a last resort and even then only to be considered along with some serious soul searching and self evaluation as to how you got in the situation where this even sounds like a good idea to begin with.
The SmartMoney article claims that:
… right now, the cheapest bank for many borrowers—especially those who feel secure in their job–is their own 401(k).
But who really feels secure in their job right now?
They also say that you’ll be paying yourself back with interest instead of paying a bank. The implication here is that a bank would just be taking your money for profit in form of interest, while interest paid on a 401k loan is money in your pocket. But with a 401k loan I think you’re really only stealing from your future.
Besides the financial penalties discussed above, borrowing from your 401k sets you back on the road to retirement and for many people that leads to increased risk because they feel the need to “make up for lost time” and invest in more aggressive (i.e. risky) funds then they should.
Still, if you find yourself in a position where you’re being crushed with high interest debt and your retirement savings are at risk anyway (perhaps through a divorce settlement?) then it may be the path of least pain and get you back on the road to retirement quicker. Just think over the implications first.
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Posted: April 11th, 2011 | Author: Joe | Filed under: Credit | Tags: Borrowing, Credit, Credit score, Debt, Guest Post, loans | No Comments »
Credit repair is a hot topic these days – largely because it is a crucial element of overall financial health. Without maintaining good credit, you are not only likely at the mercy of lenders should you ever need financing, you are also guaranteed to spend more money than a consumer who maintains a good credit record and solid credit scores.
Why Credit Should Matter Now
Many consumers make the mistake of waiting until the last moment to do something about their credit scores and only make the attempts when they need to secure financing. But waiting until the last minute these days is a measure in ‘too little, too late’. It is important to do something about your credit score now regardless of your timeline or need for financing.
Here is an overview of situations where a bad credit score will cost you big bucks:
Mortgage lenders are scrutinizing credit histories and scores harder than ever thanks to the near-meltdown of the industry a few years ago. There are now stricter lending laws being imposed and borrowers need to come to the table with really good credit in order to have the most opportunities for an affordable home loan. Those without good credit scores will have a tougher time getting lender approval and for loans that are approved the interest rate of the loan will be higher, meaning you’ll spend a lot more money over the life of the loan than if you were eligible for a lower interest rate. Your loan terms and conditions may also be stricter such as requiring more than the typical 20% down payment on your loan.
Auto Loans
Like mortgage lenders, auto loan financing may be impossible for those with bad credit or the interest rate you pay on the loan may be much higher than for other buyers. As a result, you will pay more for the vehicle over the life of the loan, which is essentially a price you can’t make up in the value of the vehicle since most vehicles depreciate as soon as you drive them off of the sales lot.
It is not just financing companies that are looking closely at credit scores. Insurance providers are pulling credit scores on customers in order to gauge their potential for claims being filed. Insurance providers use a theory that credit history is relative to claim potential, meaning that those with lower scores are more apt to file an insurance claim. If you have a low score, you will have to pay a higher premium on your auto and home insurance than consumers who have better credit backgrounds.
Utilities/Consumer Services
There are many regular service providers who will pull credit scores before approving service applications. If customers have low credit scores, most providers will require a hefty down payment or prepayment on accounts to prevent risk of the bill not getting paid. For instance, with a low credit score, you may have to put up several hundred dollars on your mobile phone account or if you open a new account with the electric company, a deposit might be necessary to start services. Such deposits are often held for up to a year to gauge prompt payments each month and only then will you receive a credit.
If you are looking to apply for a new credit card but have a poor credit score, your options will be seriously limited. In some cases, you will only be eligible for secured cards, which means you need to send several hundred dollars as a prepayment. Secured cards will also require you to keep up with timely payments to keep the account loaded and change significant fees for transactions and penalties for late payments or over-the-limit charges.
While credit repair is possible by anyone, what is important to remember is that it is a time-intensive process that should begin as soon as possible. Even if you are not anticipating a need for a loan in the near future, there are too many other resources relying on credit scores for you to ignore the importance of your credit standing. Over time and with good financial management practices, you can improve your credit score to where it should be. Today, lenders are looking for borrowers with a credit score of 730 or higher in order to afford the best deals and the most options.
This is a
guest post by Ed O’Brien. Ed is an expert writer on personal finance, specializing in
credit repair. You can find more of his articles located at
CreditRepair.org.
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Posted: April 6th, 2011 | Author: Joe | Filed under: Retirement | Tags: Debt, Retirement, Retirement planning | 2 Comments »
This is a sad story about Susanna Wilson, 70, who never planned for the future. She has no retirement savings and now realizes she “can never retire”.
Not to seem heartless, but this is another example of poor (or no) planning, and bad choices. Not everyone is born a good decision maker, and some are better than others. But by and large, decision making is a skill and it can not only be learned, but it can be improved.
I offer this story to my readers as a means to learn form another’s mistakes, and remind ourselves of the importance of proper planning and not letting our emotions rule our decisions entirely.
Planning is important.
Despite owning a several businesses (a clothing line, perfume maker for example) and earning $65,000 a year in the 70′s she never saved a dime for retirement. Being self employed, she could have saved up to 25% of that per year in a Keogh plan – tax deferred! That’s $16,000 per year in her account, and off the top of her tax bill!
Following your heart and ignoring your head can be costly.
Her free spirited ways led her to leave University of California, Berkeley before graduating to follow and marry her college sweetheart, a “minimalist sculptor and sometimes rock musician.”
I’m not saying you have to be Mr, Spock all your life and let your passions wither on the vine in a desert of logic, but if it was truly meant to be, then it would still be meant to be after she graduated college. Postponing would have at least given her a degree – an important commodity in the decades following her stint at Berkeley in the late 1950′s.
Besides, in all likelihood, she would have realized it wasn’t meant to be and she could have saved herself one of her eventual two divorces. Incidentally, Divorce is also a costly “life event”, especially for Ms. Wilson since she never received any alimony.
There are always possibilities.
Flash forward to today and things look bleak. Ms. Wilson lives on her social security check of $900 a month, and a one day a week job at a local jewelry store for $12.50 an hour.
She’s got a house with a $5,477 mortgage, and about $9,000 in credit card debt. The credit card debt is from living expenses, so her income is clearly not enough to get by.
The good news in all this is her house. She inherited it with no mortgage, but had to take out a mortgage to pay for repairs. That leaves her with more than $150,000 in equity and since she’s over 62, she’s a candidate for a Reverse Mortgage. In fact, she’s probably a poster child for one!
A reverse mortgage would get her a monthly check from the bank. Not to mention, it would eliminate her mortgage bill in the process. Increased income, and decreased expenses – it’s all around winning!
Read Susanna Wilson’s story here.
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Posted: April 1st, 2011 | Author: Joe | Filed under: Debt | Tags: Debt, gett, getting out of debt, Saving Money | No Comments »
Kiplinger.com recently profiled a young woman who was determined to wipe out her $70,000 in debt in order to stay at home and start her family. As regular readers of this blog know, I am a big supporter of living on a single income to raise a family. That being said, I acknowledge it is a lifestyle choice that is not for everyone.
But the fact remains that getting out of debt is always a good thing, and it’s especially helpful if you do need to live on a single income. After all, when a sizable chunk of your income is going toward paying off your lifestyle of the past it leaves you somewhat handcuffed in times of emergency or financial hardship.
So, how did Jaime Tardy (the woman in the Kiplinger article) accumulate her $70k in debt? Well, it broke down like this:
- About $26k in student loans
- $25k home equity loan
- $20k car loan
Looking at the breakdown of her debt, it seems to me like a fairly average breakdown for most people.
Her secret to getting out from under all this debt – and gaining a $23,000 surplus in savings?
Hard work, downsizing and determination to doing what it took.
That’s it folks. It’s not Rocket science. Getting out of debt is simple, but that doesn’t mean it’s easy. Jaime and her husband took on extra work where they could. The downsized their lifestyle by trading in their new car for a used car, canceling the cable and cell phones. They then took all the money they were saving and the extra money they were making and whacked off the debt.
While my wife and I were (thankfully) never quite so far in debt when we decided to get our financial house in order, we followed many of the same steps. We’ve cut our cable bill by $40 a month, traded our costly monthly cell phone plan for a pay-as-you-go Tracfone and bought a used car instead of a new car when we needed something bigger for the expanding family.
It’s not always easy, but it can be done. It’s amazing how much you can do when you put your mind to it and you realize it’s for a short period of time. And chances are, after that period of time where you’ve cut costs and busted your rear to make that extra you’ll discover you’ve changed your whole outlook on money an materialism. You’ll likely discover you’ll lead a simpler, happier life as a result
You can follow Jaime on her new goal of amassing $1 million on her blog: http://www.eventualmillionaire.com/
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