Cash and Debt Management

Other Borrowing Options

If you are not a homeowner or don’t have enough equity in your home from which to borrow, or you simply don’t want to tap into any home-equity you may have, there are a number of other approaches you can take to borrow money. Borrowing sources include retirement accounts (such as 401(k) plans), stock brokerage firms, life insurance loans, business loans, personal loans, and borrowing from relatives or friends.

Borrowing From A 401(k) Plan

If you participate in an employer’s 401(k) plan, find out if it allows you to take loans against your account balance. Many 401(k) plans allow loans. But remember... this is a retirement fund first and foremost!!!! We always recommend that you save for your retirement first... it’s the single largest commitment you have to fund - even bigger than the purchase of a home. So if you are going to borrow from a 401(k) plan, do it knowing that it will get in the way of your retirement plans.

Consider All Available Options

Most 401(k) plans offer loans. Instead of withdrawing your savings from the 401(k) plan, you can borrow from your own 401(k) plan account. 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. Loan terms are usually no more than five years for general loans and no more than 30 years for home acquisition loans. Loans must be paid back on a regular basis - quarterly, monthly, or biweekly, but at least once each quarter.

Since your loan is secured by your 401(k) plan, Department of Labor rules won’t let you borrow more than 50% of your account balance. 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 tax law, a 401(k) plan can permit you to borrow as much as $50,000 or half of your vested benefits in the 401(k) account, whichever is less. 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. If your vested 401(k) plan account is less than $10,000, you can borrow up to your vested account balance. 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.

Of course, 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.

Interest Rates

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 the prime rate plus one percent to a Share Term Certificate.');" onmouseout="return nd();" onClick="return false;">certificate of deposit rate (CD) plus 2 percent.

Determine The True Cost Of Borrowing

What does it really cost you when you borrow from a 401(k) plan?

When you borrow from a 401(k) plan, 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... you’ve borrowed it and it’s out doing something else. So, although the interest you pay on the loan goes back into your 401(k) account, the true cost of the loan is the amount you would have earned on that money had you not borrowed it from the account. It’s what we call opportunity cost.... and it’s a tricky concept. Don’t fall for those pitches that ‘you’re paying yourself back.’ That’s not all that’s happening... you’re also missing out on the investment earnings on those funds that were borrowed!

On the other hand, borrowing from a 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.

The moral of the story is that besides the ‘paying yourself back’ issue, not participating in 401(k) investments can work to your advantage or disadvantage, depending on the investment performance over the term of the 401(k) loan.

Penalty-Free IRA Withdrawals

Even though you are not permitted to borrow from your Individual Retirement Account, you can make a penalty-free withdrawal under certain circumstances. The 10% penalty that applies to most withdrawals from IRAs before the account owner reaches age 59 1/2 will not apply to the following types of withdrawals:

• Distributions made after the death of the account owner.*
• Distributions made due to disability of the account owner.*
• Withdrawals used to pay deductible medical expenses.
• Withdrawals used to pay health insurance premiums for certain unemployed individuals.
• Withdrawals for higher education expenses of the taxpayer, spouse, children, or grandchildren.
• Withdrawals for a qualified first-time homebuyer, subject to a $10,000 lifetime limit. The withdrawal must be used to acquire a principal residence of the taxpayer, spouse, child, grandchild, or ancestor. The withdrawal is permitted, generally, if the taxpayer has not owned a principal residence in the preceding two years.*

* If these distributions are made from a Roth IRA, they will also be tax-free provided the Roth IRA was held five years or more.

CAUTION!: Be careful not to jeopardize your retirement savings by making withdrawals from your IRAs. Explore other ways to borrow first.

Borrowing From Your Brokerage Account

If you have a brokerage account you may be eligible for a loan. Many firms make it easy for you to borrow money against the value of the investments you have on account with them. These loans are typically called margin loans. The investments in your account are used as collateral for the loan. You may use the money that you borrow for any purpose, although most investors borrow on margin to purchase securities, i.e. stocks, bonds, etc. So how does a margin loan work?

• Investors are usually permitted to borrow about 50 percent (this may be less depending on the volatility of the stock involved and various other factors) of the current market value of their investments.
• Interest rates are typically low.
• There is usually no fixed repayment schedule, but you may have to put up additional collateral (stocks, bonds, etc.) if the market value of your investments in the account decline.
• Some firms may require that you make up the difference in cash if the market value of your investments used for collateral declines.

Is The Interest Tax Deductible?

If you take the cash you receive from a margin loan and don’t use it to purchase other investments, the interest is not deductible. On the other hand, if you use the money to buy investments, the interest is fully deductible to the extent it does not exceed net investment income. Here is a formula to help you calculate net investment income.

Dividends + Interest income - Investment expenses = Net Investment Income

CAUTION!: Net capital gains are not included in net investment income. But you can make a special election to include net capital gains in investment income. Contact your tax advisor for details.

CAUTION!: If you use the money to buy tax-exempt securities, the interest will not be deductible. The theory is that if you don’t have to pay income tax on the interest income, you should not be entitled to a deduction for the interest expense.

Life Insurance Loans

Certain types of life insurance policies include a savings component, or cash value. You may borrow against the accumulated cash value at relatively low interest rates. Essentially, you are borrowing from your own savings. Interest rates may be fixed or variable depending on the policy. Be sure to ask your insurance agent if the dividend rate will be reduced when you take out a loan. Also ask them to send you information regarding the loan provisions so you will fully understand all the implications of your loan. Provisions will vary with different policies and insurance companies.

Life insurance loans can be a convenient way to borrow money, especially if the interest rate is low. These loans do not have to be repaid, but keep in mind that the outstanding balance will be deducted from the death benefit the beneficiary will receive when you die. It is important that you at least pay the interest as it comes due, since interest will continue to compound on the interest owed on the loan.

CAUTION!: If you use the cash value in your insurance policy to pay the interest on a life insurance loan, you may use up all of your cash value, which can cause your policy to lapse.

Is The Interest Tax Deductible?

Interest on life insurance loans is treated as non-deductible personal interest, with one exception. If you use the funds to purchase investments, the interest may be deducted as investment interest.

You must meet the following criteria.

Business Loans

Have you always dreamed of opening your own business but never had the money to do it? Businesses are typically financed from a variety of different sources. These sources can consist of a combination of the following:

• Borrowed money
• Contributions from owners
• The sale of an existing business

If you need to borrow, there is a benefit when borrowing money for business reasons - the interest is tax deductible!

Businesses usually have an option to borrow at either fixed or variable rates of interest. They also may be able to get lines of credit and borrow money when it is needed.

Whenever you borrow money, whether to start a business or to purchase new equipment for it, you will have to provide collateral for the loan or prove to the lender that the business will be profitable enough so that you can repay the money. You may be able to negotiate better with a banker with whom you already have a relationship. If the banker is aware of your excellent credit history, and you have money deposited at their institution, things may move more smoothly.

It is a common practice for a lender to request financial information about you and/or your business. Be prepared to provide current financial statements and income tax returns. You may also need to have personal financial statements prepared if your business is just starting. Ask your lender for details. Most lenders will want to see a ‘business plan’; i.e. how you expect to do business and make a profit.

Is The Interest Tax Deductible?

If you are obtaining a loan to be used in your business, the interest is tax deductible. If you are obtaining a mortgage to buy business property -- real estate to be used in your business - the interest on the loan is also tax deductible, but the points are not fully deductible in the year of the purchase. Instead, they must be amortized, or deducted in equal amounts each year, over the term of the loan. This includes property on which you receive rental income.

Personal Loans

There are many different types of personal loans that you may be able to get if you are unable to take advantage of any of the other alternatives discussed in this section. Personal loans, or consumer loans, are the least favorable way to borrow money, since they typically carry very high interest rates; and the interest you pay on the loans is not tax deductible. Personal loans include secured and unsecured loans.

Secured Loans

Secured loans are loans that are guaranteed by some form of collateral. Here are some common types of collateral:

• Automobiles and Trucks
• Shares of Stock
• Boats and Recreational Vehicles
• Savings Accounts

Interest rates vary with the type of loan, the amount, and the term of the loan. Because you have put up an asset as collateral, the rate is usually lower than if you do not put up any collateral.

A lender will perform a credit check before approving a consumer loan. If you do not have a good credit rating and/or you don’t already have a reputation established with the lender, you may be required to have a co-signer on the loan. A co-signer will be obligated to pay the loan if you should default.

Unsecured Loans

An unsecured loan is issued on the basis of your credit rating only. Since the lender doesn’t have a claim to any of your assets if you should default on the loan, this is a riskier proposition for the lender than a secured loan. Therefore, you can bet that the interest rate is going to be pretty high.

Credit Cards

Credit cards are a common type of unsecured loan or line of credit. The wise person will not use credit cards as a source of funds for borrowing. Rates are extremely high; and because you are only required to pay a minimum balance each month, debt can mount up very quickly if you are not disciplined.

All credit cards are not created equal! Interest rates charged on each card will vary, and in addition some have annual fees (which also vary.) Expect to see tradeoffs -- cards with no annual fees sometimes charge a higher interest rate. Watch also for the "grace period." This is the amount of time you have to pay the bill without incurring a finance charge. Always look for a 25 to 30 day grace period. Some credit card companies also offer incentives, such as discounts on purchases or frequent flier miles. Take these incentives into consideration when selecting your credit card company.

Get into the habit of reading the fine print. Not all credit card issuers compute their interest charges the same way. There are various methods for calculating how much interest accrues on your outstanding credit card balance each month. Each method yields a different result, either more favorable to you (see below) or the lender.

How Do You Know What Card To Choose?

If you pay your credit card balance in full every month:

• Getting the lowest interest rate should not matter to you.
• Make sure you get a no annual fee card.
• Make sure you get at least a 25 day grace period.

If you carry a monthly balance:

• Get the lowest interest rate you can find.
• Make sure you get a no annual fee card, but concentrate on a low interest rate first.
• Try to find a card that computes interest using either the average daily balance method (excluding new purchases), or the two-cycle average daily balance (excluding new purchases.) These methods work out most favorably to you, the borrower.

CAUTION!: If you are offered a credit card with a low introductory "teaser" rate, be sure you know what the interest rate will be after the introductory period is over. If not, you may be in for a surprise.

Credit Card Liability

Federal consumer protection laws protect you against unauthorized use of your lost or stolen credit card. If this happens to you, you will only be liable for up to a maximum of $50 of fraudulent charges against your card. But guard your card carefully, the work involved in clearing up a fouled credit record may not cost you much money, but you will surely make up for it, in headaches! Also see the section on "Using Your Credit Card Safely for Internet Purchases".

Debit Cards

Electronic debit is becoming more and more popular. With a debit card, you make a purchase using a card that is electronically tied into the computers of your bank and the merchant’s bank. The transaction automatically transfers cash out of your bank account and into the merchant’s account equal to the amount of the purchase. No credit is extended. If insufficient funds are on hand to complete the transaction, the bank may automatically extend credit at that time, but that varies with each individual arrangement. A summary of your transactions appears on your monthly bank statement.

Overdraft Checking

Overdraft checking, also known as reserve checking, is a line of credit on your checking account. The bank will advance you money in your checking account in case you write a check over and above the account balance. The line of credit is usually not too high. But be careful: If you make it a habit, you will wind up paying quite a bit in interest charges. Avoid using it as a source of funds.

CAUTION!: Your overdraft checking is designed to function as a source of funds only if you inadvertently bounce a check or temporarily need a small advance of money. You shouldn’t view it as a long-term source of borrowing.

CAUTION!: Remember that interest is not tax deductible for any type of consumer loan.

Borrowing From Relatives Or Friends

If you have relatives or friends that are able and willing to lend you money, and you feel comfortable borrowing from them, doing so can be a good alternative. But always remember to establish a business-like approach. Make sure you take the steps that would be required if you were borrowing from a bank. Draw up an official note which states the following:

• Interest rate, if any -- see ‘Below-Market Interest Rate Rules’ below.
• How much you are borrowing
• The term of the loan (when the loan begins and ends)
• Collateral, if any

Also include any other information that you or the lender believes to be relevant. Failing to do so can lead to problems in the future. Relationships can be tarnished when it involves borrowing money from friends or family.

Is The Interest Tax Deductible?

Interest paid on the loan is deductible if the loan is used for business or for purchasing investments (up to net investment income.) If the loan is used to buy real estate, the interest may be deductible as long as the loan is secured by the real estate. A good way to prove that the loan is secured by real estate is to record the loan with the county where the real estate is located (or other filing place as state laws determine). But, a word of caution, you must watch out for the below-market interest rate rules! See below.

Below-Market Interest Rate Rules

The below-market interest rate rules apply where the interest being charged on a demand loan is less than a minimum rate of interest set by the IRS - something they call the applicable federal rate (AFR). The AFR changes on a monthly basis. You can call your tax advisor to get the current AFR.

If the interest rate on your loan falls below the AFR, you will be subject to a complex set of IRS rules that may result in a higher tax bill for you. Luckily, there are some exceptions to the below-market interest rate rules. If you meet one of the exceptions, you’re home free!

Exceptions to the below-market interest rate rules:

You won’t have to worry about the IRS below-market interest rate rules if the low interest rate was meant as a gift and either of the following apply:

These rules can get tricky! If your loan does not meet an exception; e.g., the low interest rate was not meant as a gift or the loan was a term loan, you should call your tax advisor to clarify the tax treatment of your situation.