These days, it seems as if the U.S. economy is circling the drain, just waiting to enter the pipes. Headlines warn of tightening credit markets, more foreclosures, fewer jobs, and higher prices. It’s not surprising that people are worried about how they are going to survive financially. Perhaps you’ve cut expenses and tapped your reserves but are still falling short. When you absolutely, positively can’t turn anywhere else for a loan, here’s where to go and what to do.
HOW IT WORKS – As credit from traditional sources becomes more difficult to get, peer-to-peer or social lending—between family members, friends, or strangers, helped along by online facilitators—is trying to fill the gap. Virgin Money US (virginmoneyus.com), for example, formalizes loans between family members and friends. “Working with us forces the parties to decide whether this is a loan or a gift,” says CEO Asheesh Advani. “We have found it reduces the default rate and the emotional fallout.” In other words, it helps to head off tension around the holiday dinner table.
WHAT IT COSTS – Virgin Money charges origination fees—from $99 for a personal loan up to $699 for a mortgage—and $9 per month to service the loan. The interest rates can be much lower and the terms more flexible than a bank’s. “We create the terms of the loan and a repayment schedule,” says Advani. A missed payment, for instance, can be spread over the life of a personal loan, typically five years.
BE CAREFUL BECAUSE – These loans are serious business. Lenders can still report late or missed payments to the credit bureaus.
IT MADE SENSE FOR – Jim Linebaugh, who, after declaring bankruptcy in 2005, was struggling to get back on his financial feet. The 50-year-old sales representative from Ann Arbor, Michigan, learned that his poor credit score meant he could borrow only small amounts of money at almost usurious interest rates. Then he discovered Virgin Money US.
Linebaugh borrowed $8,000 from his sister at 5 percent, around 2 percent higher than she could have gotten if she’d put her money in a savings account or CD. “It’s a win-win situation,” he says. “My sister gets a $175 check every month, and I’ve been able to pay off some high-interest loans and start to rebuild my credit.”
A 401(K) LOAN
HOW IT WORKS – When you take out a loan from your 401(k) retirement account, you borrow money from yourself. Depending on what your employer allows, you can access up to 50 percent of your vested balance or $50,000, whichever is less. You will have to pay yourself back, usually within five years.
WHAT IT COSTS – Typically you don’t have to pay fees to borrow from yourself, but you do pay yourself interest, usually one to two points above prime. The real cost of the loan is reflected in what you lose in future retirement savings.
Online tools can give you, at best, only ballpark estimates of the loss, and they vary widely. For example: If you have $50,000 in your 401(k), borrow $20,000 at 7 percent over five years, make loan payments of $198 every paycheck while continuing to contribute $100 to the plan, you will have lost about $3,600 by the time you retire in ten years, according to the standardandpoors.com calculator. But bankrate.com says the number is $17,010. It’s wise to hire a fee-only financial planner to calculate your potential loss. (You’ll pay about $80 to $200 an hour.)
“You’re trading future earnings for present cash,” says Keith Newcomb, founder of Full Life Financial, LLC, a financial planning firm in Nashville, Tennessee. “It’s a pay-now or pay-later scenario.”
BE CAREFUL BECAUSE – If you get laid off or quit, you have to repay the money within 60 days or claim it as income on your tax return. For example, if you lose your job after repaying only $5,000 of that $20,000 you borrowed, you have an outstanding loan of $15,000 that will be added to your $75,000 salary. So you’ll pay taxes on an income of $90,000. What’s more, if you’re not yet 59 1/2, you’ll owe 10 percent—or $1,500—as an early withdrawal penalty. (If you’re 59 1/2 or older, of course, you can simply make withdrawals—without penalty—and pay the appropriate taxes.) If you’re tempted to dip into your 401(k) because you’re in danger of defaulting on your mortgage, do your homework first. At press time, both presidential candidates had proposed easing taxes or penalties on 401(k) withdrawals. Check irs.gov for updates.
IT MADE SENSE FOR – Julie Sturgeon and her husband, Ron Kirchgessner, who’d always dreamed of owning a crafts store in their hometown of Indianapolis. But four months after they opened the store, income wasn’t covering expenses. “The buzz was terrific, but it didn’t translate into buyers,” says Sturgeon, a travel agent. “We had to get out.”
Their loans totaled $150,000, and the monthly payment was $5,000. “We wanted that debt off the table,” Sturgeon says. After liquidating their stock portfolio, they still needed to borrow $50,000 against Ron’s 401(k) from his job at a pharmaceutical company.
Now in their mid-40s, the couple are dealing with the consequences of their decision. With 25 years before retirement, they started a more aggressive savings plan and abandoned the idea of buying a vacation home. “We had it in our heads that it was unacceptable to borrow against our future,” Sturgeon says. “But in the end, it was less stressful to take the money out of the 401(k) than to try to make that huge monthly payment.”