- Where can I turn when my household income runs dry?
- February 6, 2013
Tapping a 401(k)
Perhaps the biggest upside to borrowing against a 401(k) plan is the ease at which it is done. Whereas borrowing from a bank can involve a lengthy credit application, tapping 401(k) funds is a matter of filling out a form and paying what’s usually a nominal fee, although not all plans allow this.
Most of these loans must be paid off within five years, although those borrowing for a down payment on a house will have longer than that depending on their plan. Craig Copeland, senior research associate at the Employee Benefit Research Institute, says such loans usually have a low interest rate and the money goes right back into the borrower’s own account so they’re essentially paying interest to themselves.
He says another difference between borrowing from a 401(k) plan vs. a bank is that a 401(k) loan doesn’t require the borrower’s home to be used as collateral so there’s no risk of losing it if the loan isn’t paid back.
A 401(k) loan isn’t entirely without a hitch, as a borrower would have to pay taxes on whatever funds they don’t pay back as well as a $10,000 fine. A 401(k) loan would also have to be repaid in full if the borrower leaves their job for any reason.
“You may be a better investment, particularly when the stock market is down. It kind of depends upon the timing of your loan versus markets, now that’s going to be really hard to do if you decide to take out a loan based on the markets because it is all based on timing, but in a way you are giving yourself guaranteed income back by repaying the loan,” Copeland says.
The Internal Revenue Service does allow withdrawals from 401(k) plans without the $10,000 penalty under certain hardship cases, although income taxes would still have to be paid on what was taken out of the plan.
The IRS says hardship distributions are for “an immediate and heavy financial need of the employee” including their spouse, dependents or beneficiary.
Circumstances include medical expenses, tuition, preventing foreclosure on a principal residence, certain home repairs and burial and funeral expenses. A distribution is not considered necessary if the employee has other resources available such as commercial loans and the assets of a spouse and minor children, unless the child’s assets are held in an irrevocable trust.
Given the unpredictability of the financial markets, Palmer does not recommend borrowing from a 401(k) plan. He says it’s impossible to know for sure when a bear market is happening, but the market will generally increase over time so the chance that a 401(k) loan will hurt investment growth is high.
“Oftentimes there’s an interest rate you’re paying yourself but it’s probably not what your expected return would have been on the investment that you’re taking the money out of,” Palmer says. “What I know is 70 percent of the time, plus or minus, the market goes up. So if I invest in the market my odds of success are very high and since I don’t know if it’s a bull market or a bear market if I put my money in the odds are with me.”
Van Zutphen says he borrowed from his own 401(k) plan as part of a down payment to buy out his business partner. At the time he had refinanced his mortgage and hadn’t reestablished a HELOC, but thought buying out his partner was a suitable investment opportunity.
“In this marketplace if you’re buying some real estate maybe the value of the real estate is a really great buy and an investment opportunity as well. As long as you’re gainfully employed and you can pay those things back then it’s a great tool,” Van Zutphen says. “If you’re taking it out of the plan and you’re buying something then you’re using it as an investment tool to buy a potential appreciating asset, and then you just have to weigh the pros and cons of the interest charged by the plan and the cost of funds that you could get otherwise for the down payment.”
Borrowing from life insurance
Unlike term life insurance, which is for a set period of time, whole life, universal life and variable life insurance policies come with a cash benefit that can be tapped as a resource. These plans are not only more expensive than term life insurance, their premiums would steadily increase over time if not for the cash value component.
To avoid such an increases, whole life and other such policies have fixed premiums and part of the money received by the insurance company is invested as a cash value that is attached to the policy. As the cash value grows over time, the company draws on those funds to offset the increasing cost of maintaining the policy.
It’s sort of like a savings account or a mutual fund that helps pay part of the premiums later on in life. The cash value can be borrowed from, provided it has reached a sufficient level.
Just like borrowing from a 401(k) plan, Tamkin says borrowing from a life insurance policy can hurt someone’s investment prospects even if the money is paid back.
“It may cause your investment strategy to change and you may not get the same benefit that you would have if you had invested that money in whatever the plan was going to invest in,” Tamkin says. “If your plan was to have a whole policy to save money and defer income, borrowing against it is going to reduce the benefits that you’ll accrue in the future. That may not be a wise investment decision.”
Van Zutphen says he would consider borrowing from a life insurance plan before he would opt for a home equity loan or a HELOC and he’s borrowed from his own life insurance plan before, yet it would be risky to borrow too much from the cash value as it could put a policy at risk.
“If you borrowed all the cash out of your policy the premiums you pay would be insufficient to keep the policy active,” Van Zutphen says. “The cash that was going to be used to help maintain the cost of the policy, benefits and everything else level or at a reasonable price would change because the cash is no longer there. The insurance company doesn’t get to use that cash and since they don’t get to use the cash, it’s likely that the policy will lapse.”
Palmer has a different approach entirely as he doesn’t think whole life policies are even necessary. He suggests people start with term life insurance when they’re younger but then self-insure themselves by taking what they would’ve spent on a whole life policy and invest the money instead.
“Insurance is absolutely essential but it’s for a defined quantifiable need. You have to have an insurable interest,” Palmer says. “Once your net worth gets high enough to support those that depend on you, you don’t need life insurance.”
Rather than thinking of a whole life or a variable policy as an investment, Palmer suggests keeping a balanced portfolio instead because a life insurance policy cannot beat the returns offered by an index fund.
“Generally speaking you should buy insurance as insurance and investments as investments because as soon as you mix the two something is compromised,” Palmer says. “It’s like two and two end up equaling three.”
In a reverse mortgage, also known as a Home Equity Conversion Mortgage, a homeowner is given a sum of money from a bank and when they die or move out of the house it’s sold and the proceeds pay off the loan. Interest is charged against the loan, just like a traditional mortgage that accrues over time.
Most of them are non-recourse loans, which means the borrower or their descendents will never owe more than the amount that was borrowed—as long as the home is sold in an “arms length transaction” at market value to a third party.
For example, if a homeowner dies owing $100,000 on a reverse mortgage and the home is sold for $120,000 the estate would be receive $20,000 after the loan is paid off. If the house sells for less than $100,000 the estate would receive nothing from the sale but would not owe any additional funds.
Reverse mortgages are available to those individuals who are 62 and older. If the property is jointly held, then both owners must be of the required age. The amount available for borrowing depends on the youngest homeowner’s age and which kind of loan they obtain. The borrowable limit increases with the owner’s age.
A married couple seeking a reverse mortgage might be tempted to remove the younger partner’s name from the home’s ownership in order to qualify for the largest sum possible, yet this is not an option to be taken lightly.
Lori Trawinski, senior strategic policy advisor in the American Association of Retired Person’s Public Policy Institute, points out that if only one name is on the reverse mortgage, and if that person dies first or has to move out of the home, the surviving spouse would have to either give up the house or pay off the loan in full.
“This leads to problems because in the event of the death of the person who is on the mortgage note the loan then becomes due and payable,” Trawinski says. “It’s a risky strategy and historically some people have run into some trouble with that as in non-borrowing spouses have ended up getting a due and payable notice for the loan.”
For this reason, the Department of Housing and Urban Development issued a requirement in August 2011 that couples seeking a reverse mortgage would have to meet with a HUD-approved counselor before obtaining a loan.
There are two options available for reverse mortgages. A HECAM standard loan allows the most funds to be borrowed but with more expensive fees. A HECAM SAVER loan offers lower fees but with a reduced borrowing limit (see sidebar). Trawinski says the saver option is good for those needing loans for a shorter amount of time, because they come with lower fees.
Regardless of which loan is selected, borrowers are required to maintain the property, pay property taxes and keep the home fully insured. Failing to do so can put the loan into foreclosure. They must also remain in the home or surrender it to the bank if they leave the residence for more than a year.
“You’re not gaining lifetime income, you’re gaining income for as long as you live in the home,” Trawinski says. “The loans are designed to be in place for as long as people are permanent residents of their home, so if they sell it or die or move out permanently the loan needs to be repaid.”
Loan proceeds can be given to the borrower in a variety of ways: a lump sum, a line of credit or a monthly payment for a set period of time. Trawinski says seniors often turn to a reverse mortgage as a way of paying off their regular mortgage or if they need work done on the home but don’t have enough income to quality for a home equity loan.
“In these cases sometimes a reverse mortgage can be the answer because you can borrow the money and you don’t have to make repayments,” Trawinski says. “Sometimes these loans are the only option for people who need some funds.”
Among all of these financing options, Palmer calls a reverse mortgage is the “the worst of the bunch” because of the fees involved. He suggests homeowners consider selling their house and use the cash to move into a small apartment instead, rather than paying 3 percent to 6 percent in fees.
Tamkin says someone considering a reverse mortgage ought to have considerable equity in their home and may want to consider other options first, as he estimates a $50,000 reverse mortgage loan could cost the borrower $6,000 in fees.
A standard refinancing or a new mortgage might be a better option for some, as Van Zutphen points out that it would also provide a sum of money that the borrower can use for living expenses. A reverse mortgage, on the other hand, can pay off an existing mortgage, provide a cash payout to the homeowner and eliminate the stress of making a monthly mortgage payment.
“To me that’s kind of a neat way of using a reverse mortgage as a tool, assuming the client or couple wants to stay in that home their whole lives and aren’t looking at the home equity as an additional tool that they’ll use later in life,” Van Zutphen says.Pages: 1 2
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