No one likes the idea of borrowing money, but it can be part of a sound strategy for working toward your financial objectives. Your career transition may be one of those times when borrowing money is a necessity, although being unemployed will make it difficult to secure a loan. Generally, it is a good idea to use your own savings first. These savings may be in the form of cash or other investments such as stocks and bonds.
Should I Use My Own Savings or Borrow Money?
Before you consider borrowing, review your non-retirement cash and non-cash assets on your net worth statement. Using what you already own to pay your expenses will typically cost you less and hurt you less financially in the long run.
What Are the Best Ways to Borrow Money?
Once you decide that you have no alternative but to borrow, you need to evaluate which type of loan is best for you. In most states, if you're a homeowner, there are some tax-advantaged ways to borrow against the equity in your home. If you have no equity in your home or you are not a homeowner, you will have to consider other borrowing techniques that do not offer the same tax advantages but can still help you to address your financial objectives. Following is a list of borrowing alternatives:
You need to go through three steps when deciding to borrow:
SUGGESTION: A home equity line of credit provides easy access to the equity in your home. The problem is that if you're already out of work, your loan application may be denied. Our advice: If you're still employed, establish a line of credit now. But be extremely cautious in using it.
A feature of many 401(k) plans is the ability to borrow from yourself. In other words, you can borrow money that you contributed to your plan, within certain limits, and pay yourself back. Loans are not considered withdrawals by the IRS, so your loan amount is not taxable, and you don't pay the 10% early withdrawal penalty. But watch out: Borrowing from your 401(k) plan may cost you more than you think. See the section "True Cost of Borrowing" below.
How Much Can I Borrow?
In general, Department of Labor rules won't let you borrow more than 50% of your vested 401(k) account balance, but there are exceptions (see below). There are also certain tax rules that limit the amount you may take as a loan without it being considered a taxable distribution.
Under current law, a 401(k) plan can permit you to borrow as much as $50,000 or half of your vested account balance in the 401(k) plan, whichever is less. If your vested 401(k) plan account balance is less than $10,000, you can borrow up to your vested account balance. If your vested account balance is at least $10,000, you can borrow up to $10,000, even if 50% of your vested account balance is less than $10,000. The $50,000 amount is reduced by the highest balance of any loan you had in the previous 12 months, even if you've paid it off. For example, assume your vested account balance is $100,000 and in June of the current year you had a loan balance of $10,000 you paid off. In April of the following year you could not borrow more than $40,000.
However, a specific employer's 401(k) plan does not have to permit loans this large. Also, many plans have a minimum amount you can borrow, usually $500 or more.
401(k) plans are required to charge interest on a loan at the going rate for interest on similar loans in the community. Reasonable rates range from prime rate plus 1% to a certificate of deposit rate (CD) plus 2%.
If you don't make payments on your loan in a timely manner or if you leave your employer without having paid off the loan, or without making arrangements to repay loan (if permitted), the IRS will treat the loan balance as though you took a withdrawal from the plan. Consequently, you will owe income taxes on the loan balance in the year you fail to pay the loan and you may also face the 10% early withdrawal penalty. So it is important that, if you take a loan, you keep up with the payments. And before you leave a job, pay off your 401(k) plan loan first, or, if the employer's plan permits it, arrange to make payments after you leave.
Determine the True Cost of Borrowing
What does it really cost you when you borrow from your 401(k) plan?
When you borrow from your 401(k) account, you no longer earn investment returns on the amount you borrow from the account. In effect, that money is no longer in the 401(k) plan earning money. So, although the interest you pay on the loan goes back into your 401(k) account, the true cost of the loan is the interest you are paying plus the amount you would have earned on that money had you not borrowed it from the account. You're missing out on the investment earnings on the funds that were borrowed. It is called "opportunity cost," and it is a tricky concept. On the flipside, borrowing from your 401(k) plan can work to your advantage if the market is losing money. By pulling the money out as a loan, you're not participating in a losing market. Not participating in your 401(k) investments can work to your advantage or disadvantage, depending on the investment performance over the term of your 401(k) loan.