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.”
HOW IT WORKS – If you’re at least 62 and own your own home, you can tap your equity by taking out a reverse mortgage. You’ll need an appraisal, an inspection, a mortgage broker, and a lender—just as you do for a traditional mortgage. Payments on the loan, however, are reversed: The bank pays you.
The amount you get depends on your home’s value and location, current interest rates, and, if there are co-borrowers, the age of the youngest one. As you dip into your reverse mortgage, your debt increases and interest is added to your loan balance.
The loan comes due when you die, sell, or move away permanently—perhaps to live with your children or at an assisted-living facility. Your heirs will still inherit the house, but they will also inherit the debt—which they will have to pay off within six months, often by selling the house.
Most reverse mortgages today are home equity conversion mortgages (HECMs), insured by the Federal Housing Administration (FHA). HECM loan amounts are based on a new national equity limit that had not been released at press time (visit hud.gov for an update). Your loan will be based on either your home’s appraised value or the new equity limit, whichever is less. And you won’t get all of that: Expect between 55 and 85 percent. You can take the money as a lump sum or a monthly cash advance or leave it in a line of credit to draw on as needed.
The FHA requires that you see a reverse mortgage counselor before applying for an HECM mortgage, to make sure you understand the process and the potential pitfalls. “If it’s important for you to stay in your house, a reverse mortgage might be a good tool,” says Rick Jurgens, a consumer advocate at the National Consumer Law Center in Boston.
WHAT IT COSTS – Reverse mortgages are expensive, although the Housing and Economic Recovery Act of 2008 has partially addressed that. Origination fees used to be a flat 2 percent of the home’s value. The new law allows for 2 percent on the first $200,000, then 1 percent of any remaining value, with a $6,000 cap.
BE CAREFUL BECAUSE – If you take the money all at once or let your monthly advance build up in your bank account, your eligibility for Medicaid and Supplemental Security Income may be affected. “If you tap your home equity through a reverse mortgage and use it now for, say, a vacation, your nest egg won’t be there if an urgent medical or other need arises later,” says Jurgens.
Be especially wary of any salesperson who tries to get you to use a reverse mortgage to finance an annuity or long-term-care insurance. “The seller will likely pocket a big commission, and after factoring in the costs of a reverse mortgage, you are almost sure to lose financially,” says Jurgens.
IT MADE SENSE FOR – Mary Falso of Goodyear, Arizona, who retired with a pension and Social Security from her job at the Veterans Administration. Each month, the 68-year-old struggled to pay her mortgage and a home equity loan, which totaled $900 a month. Fearing she’d have to go back to work, she opted for a reverse mortgage.
Falso was able to pay off her traditional mortgage and home equity loan, totaling $110,000. Her monthly expenses are now manageable, and she has $40,000 in a line of credit as a cushion. “Two words come to mind when I think about my reverse mortgage,” she says. “Financial freedom.”
HOW IT WORKS – “With the current downturn in the economy, people are rethinking all their expenditures, including their life insurance premiums,” says David Fastenberg, president of Life Insurance Solutions LLC in Jacksonville, Florida. If your premiums are too high, or if the kids are grown and you don’t need the policy anymore, or if you have a better use for that money—such as health care expenses—you can sell your whole-life policy to a third party in a transaction called a life settlement. (Unlike term insurance, a whole-life or universal-life policy builds cash value-think of it as a combination savings account and insurance policy.)
In general, to qualify you have to be 65 or older and have a whole-life policy with a face value of at least $250,000 (or a policy that can be converted to whole life). An insurance broker shops your policy around to life settlement providers who represent buyers—usually investment firms. They will offer more than the cash surrender value—the amount available when a policy is canceled—but less than the death benefit. How much more depends on your age and your health: The older and sicker you are (fortunately or unfortunately), the more you’ll get. The investors pay the premiums as long as you live, and collect the death benefit when you die.
And they keep tabs on the health of their investment—you. “Follow-up is usually done annually, but it can be quarterly,” says Fastenberg. You can be the contact or nominate someone you know if you don’t want to take the “So how are you feeling?” calls.
WHAT IT COSTS – Life settlements are relatively new and not yet well regulated, so how do you know whether you’re getting the best deal? Tom Orecchio, chair of the National Association of Personal Financial Advisors, suggests the following:
- Ask a fee-only insurance or financial expert to evaluate your situation and determine your policy’s worth.
- Make sure your broker discloses his commission. “You’re better off paying a commission on the value of the purchase price than on the face value of the policy,” says Orecchio. “Try to keep it between 3 and 6 percent.”
- Don’t accept the first offer. Ask your broker for at least three bids.
BE CAREFUL BECAUSE – You may be selling an asset for much less than its value. And there is still a life insurance policy on you—now held by strangers—so it may be difficult to get additional insurance.
IT MADE SENSE FOR – Brian Redman, who had a successful career as a race-car driver, winning at tracks throughout Europe and the United States. He’d carried a $1 million life insurance policy for years, with an annual premium of $6,500. When he learned at age 69 that the policy would expire when he turned 70—and would cost $36,000 to renew—he felt like he’d just hit the wall at Daytona. “I politely declined to keep the policy,” he says. But then his insurance agent told him about life settlements. He sold his policy and received a check for $86,000.
Now 71 and living in Vero Beach, Florida, Redman shows up occasionally at his old haunts to take a classic car around the track. “But every few months, I get a call from a very nice lady who inquires after my health,” he says with a laugh.
REMEMBER, these unconventional tools may ease your cash crunch, but read the fine print before signing anything. They all come with significant, even costly, downsides. Never enter into any of these arrangements without consulting a fee-only financial planner (who doesn’t sell financial products). Find one at napfa.org.
“People may have to resort to last resorts,” says Mary Schapiro, CEO of the Financial Industry Regulatory Authority, a nongovernmental agency focused on investor protection and market integrity. “But they should take these steps with their eyes wide open.”
MORE WAYS TO BORROW CASH
Peer-to-peer lending sites aim to inject a little Main Street into the traditional Wall Street approach of banks. As the field grows, the Securities and Exchange Commission is racing to impose regulations. The SEC-approved lendingclub.com facilitates loans between lenders and borrowers with good credit. Prosper.com puts a loan out for eBay-type bids-the borrower takes it or leaves it. (At press time, the site had halted new activity and asked the SEC for permission to resell loans.) Loanio.com focuses on loans for riskier subprime borrowers. College students looking to finance their educations can try fynanz.com and greennote.com.
YOU NEED A SAFETY NET
The annual U.S. personal savings rate has been hovering around zero since 2005. Credit is increasingly scarce. Your best defense: Start living within your means and put away some cash for emergencies.
[step-list-wrapper title=”” time=””] [step-item number=”1. ” image_url=”” title=”Institute a ‘real money only’ policy.” ]”Try using only cash or a debit card for a day, a week, a month,” says Rick Salmeron, president of the Salmeron Financial Network in Dallas. “You’ll think twice about making any purchases.”[/step-item]
[step-item number=”2. ” image_url=”” title=”Take the checkout quiz.” ]Before buying anything, says Marcia Brixey, author of The Money Therapist, ask yourself, Do I need this? Will I use this? Am I buying this because it’s on sale? How many hours will I have to work to pay for this?[/step-item]
[step-item number=”3. ” image_url=”” title=”Get rid of what you’re not using.” ]Do you really need three-way calling? Do you watch all those premium channels? When was the last time you used your gym membership?[/step-item]
[step-item number=”4. ” image_url=”” title=”Put away your credit cards, then focus on paying down the balances.” ]”Pay off the card with the highest interest rate first,” says Roseann Bunshaft, associate vice president with Wachovia Securities in Southampton, New York. “After you pay that off, add the payment you’ve been making on that bill to the minimum payment due on the card with the next highest interest rate,” she says. “And keep going until all your balances are paid off.”[/step-item]
[step-item number=”5. ” image_url=”” title=”Pay your bills on time.” ]Late fees on credit cards can run as high as $38 for missing the due date by even one day. Worse, paying late may hurt your credit rating. A bad rating can mean paying as much as 15 percent more for that new-car loan, instead of 6 or 7 percent, the average for anyone with good credit.[/step-item]
[step-item number=”6. ” image_url=”” title=”Avoid banking fees.” ]A bounced check will run $28, on average. Keep track of all your expenditures, withdrawals, and fees. Allow at least three business days for deposits to clear. Consider overdraft protection, but resist the temptation to use it as a line of credit.[/step-item]
[step-item number=”7. ” image_url=”” title=”Start saving today.” ]How much per month depends on what you’re saving for, but 10 percent a paycheck is a good beginning. Set up direct deposits, and establish a goal and a target date.[/step-item][/step-list-wrapper]