Bank of ONE

Need a loan? Borrow from yourself

Your Money

May 23, 2004|By Lorene Yue

It wasn't long ago that an unexpected or unusually large expense -- say a roof in urgent need of repair or a looming tuition bill -- meant a visit to the loan officer of the local bank. But these days more people are finding a new financial resource that's easier and cheaper -- themselves. "A bank is going to ask you for collateral," said Denny Cummings, who works for Merrill Lynch in Chicago. "The way they loan you money without collateral is a credit card, and the interest rate on that is not favorable." Here are a few ways that you can tap into the bank of you:

Your home: Equity vs. refinancing

You can tap into the value of your home either by refinancing and putting extra cash into your pocket or opening a line of credit based on the equity you have built up in your home. Both options have been popular thanks to rising home values and low interest rates. Both are easy to do.

Rising home values can help you refinance your mortgage and tap into the increased equity in your home. Say you paid $300,000 for your house with 20 percent, or $60,000 down, and took out a $240,000 loan. Now your home is worth $360,000, so your equity is now valued at $120,000.

If you get a new mortgage at 80 percent of your home's current worth, $288,000, you can pay off the first loan of $240,000 and pocket the extra $48,000.

A home equity line acts like a revolving line of credit and the interest you pay is tax deductible up to a certain amount.

The plus side is the same for both the re-fi and equity line: Easy access to your money.

But that's also the negative side.

"I've seen people charging up their credit cards and transferring all that over to a home equity credit line," said Donna Gestl, president of New Vision Financial Planning in Baltimore. "Then a couple of years later, when the equity in their home has gone up and they've charged back up all their cards, they do it again."

And you risk foreclosure if you default on the equity loan or new mortgage.

Life insurance: No deadline to repay

This works only if you have cash value in your whole or permanent life insurance policy. Those types allow you to build up the cash value the longer you hold the policy.

The upside is that you don't have a repayment deadline, and an interest rate change should not affect you.

The downside is that you could be leaving your beneficiaries in a lurch should you die before you pay it all back.

"If the beneficiary is your spouse and you have young children they won't get near enough money," Cummings said.

Investing: Margin can backfire if portfolio shrinks

If you have a stock and bond portfolio with a brokerage firm, you can borrow against a portion of it with a margin account. You'll pay interest to the brokerage firm, but in some cases a portion of the interest could be tax deductible. It's best to check with a tax adviser to see if that applies in your situation.

The hitch? If the stock market heads south and the value of your portfolio falls, the firm can require you to cover the shortfall between how much you borrowed and the now lower value of your investments. If you can't pay up, you'll be forced to sell some of your securities -- at a loss.

Retirement accounts: IRA loans short-term, longer for 401(k) borrowing

Financial planning experts are sharply divided on whether you should tap into your retirement savings for quick cash. Some say to never touch your 401(k) plan for anything other than retirement needs. Others say it is OK if that is your only resort and if you fully understand the risks involved.

"It is hard enough to get people to put money into a retirement account," said Kevin Leahy, director of financial planning for KR Wealth Management LLC in Farmington, Conn. "I would hate to see them pull it out quicker than they need to."

If you need money for a short period and have an individual retirement account, you can borrow from it. You'll have to pay it back in 60 days, though, and you can only tap that well once a year.

You can also borrow against your 401(k) plan, which typically comes with a low interest rate and up to a five-year repayment plan. The interest is not tax deductible, but it goes back into the account, so you are essentially paying yourself.

However, there are a number of hazards in borrowing from your 401(k). If you haven't reached retirement age and you don't pay it back on time or when you leave the company, the loan is considered a premature distribution. You'll get socked with a 10 percent penalty fee if you are under 59 1/2 years old, and you'll pay taxes at your individual rate regardless of when you withdraw the money.

Numbers crunchers will add that you are sacrificing your rate of return on the entire 401(k) if you take some money out prematurely. If your money was growing at 7 percent to 8 percent a year and you are paying 2 to 3 percent in interest on the loan, then there's going to be a shortfall, Cummings said.

Lorene Yue is a Your Money staff writer.

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