Weathering Tough Financial Times—The Long-term Costs of Quick Cash
Rising costs of food and fuel, declines and volatility in the housing and financial markets, and an ever-tightening credit crunch have gathered to form a perfect storm that could lead some Americans to make poor financial choices. Not so long ago, those who faced a temporary financial setback, such as the loss of a job, a health emergency or an unexpected expense, could borrow or use credit to get by—and many still do. Recent data from the Federal Reserve show consumer use of credit cards and revolving lines of credit at an all-time high.
But while some Americans use credit as a safety net to weather life's occasional storms, others rely on it as a way to finance a lifestyle they otherwise could not afford. Debt has become a norm in the U.S.—and, according to the Center for Responsible Lending, households are finding it difficult to break that cycle. Similarly, personal bankruptcy filings continue to rise—as does the age at which consumers declare bankruptcy. A recent study by AARP found that in 2007 more than 1 in 5 debtors were over the age of 55, compared with 1 in 10 in 1991. The study also found that the rate of personal bankruptcy filings among those ages 45 to 54 had jumped by more than 48% from 1991 to 2007. For those ages 55 to 64, the rate rose by 150%—and for those ages 75 to 84, 433%.
In tough financial times, many investors feel pinched for cash—and some may search for different, often risky ways to make ends meet. Troubling trends include investors leveraging or prematurely depleting their retirement savings, trading in their insurance policies in transactions known as "life settlements," and tapping their home equity through reverse mortgages.
FINRA is concerned that some investors may be risking their most valuable assets in an effort to raise cash quickly-including those in or near retirement, who may not have time to recover their losses. We are issuing this Alert to warn investors about the long-term consequences of these strategies and to provide tips on weathering tough financial times.
Forgoing Your 401(k)?
When finances get tight, you might be tempted to free up money in your budget by cutting out contributions to your 401(k) or employer-sponsored retirement plan—or to cash out altogether. Under the tax code, plan providers can allow hardship withdrawals in certain situations—to prevent eviction or foreclosure on a primary residence, for instance, or to address a severe financial hardship. A recent report confirms that hardship withdrawals rose significantly between 2007 and 2010. And that trend appears to be continuing.
In addition to withdrawals, other products and strategies have emerged that allow investors to tap their retirement nest eggs prematurely—such as "72(t) withdrawals" and 401(k) debit cards. Some financial advisers have been touting Section 72(t) of the Internal Revenue Code as a "loophole" that allows you to retire early by obtaining penalty free withdrawals from an IRA before age 59 ½ through a series of substantially equal periodic payments. The pitch may promise that you can cash in your company retirement savings in your 50s, reinvest the money, and live comfortably off the proceeds for the rest of your life. But the hitch is that these early retirement strategies sometimes assume unrealistically high rates of return on the recommended investments and require imprudent rates of withdrawal each year.
Another relatively new way investors can access funds from their employer-sponsored retirement plans is the 401(k) debit card. When investors use a 401(k) debit card, they borrow from their 401(k) account. If their plans allow these cards and they choose to use this feature, their employers must first approve the amount that can be borrowed. Investors can then use the funds for any purpose and usually don't have to explain why they need the money or how they intend to spend it. The danger is that taking money out of your retirement savings, even for a short period of time, can have enormous repercussions for your retirement security—particularly if you never put the money back.
Before you tap your 401(k), know that there are several good reasons to keep your retirement savings intact:
If you can tighten your belt in other ways and continue contributing to your 401(k), you can also take full advantage of the array of additional benefits that retirement plans offer. For example, contributing pre-tax dollars to a 401(k) immediately reduces your taxable income and lowers your tax bill. And if your employer matches a percentage of your contributions, every dollar you contribute entitles you to free money.
But if you really need the money, be aware that you may be better off borrowing from your 401(k) than taking a withdrawal. Depending on your plan's terms, you may be able to borrow at a lower rate from your account than you could from a bank or other lender, especially if you have a low credit score. And you won't have to pay taxes on the proceeds of your loan as you would with a withdrawal. At the very least, you should check with your plan administrator to learn whether this option makes sense for you before seeking to cash out. To learn more, read Smart 401(k) Investing.
Living Without Life Insurance?
Some older investors who are strapped for cash consider selling their existing life insurance in transactions known as life settlements. A life settlement, or "senior settlement" as they are sometimes called, involves selling an existing life insurance policy to a third party—a person or an entity other than the company that issued the policy—for more than the policy's cash surrender value, but less than the net death benefit.
Life settlements can be a valuable source of liquidity for people who would otherwise surrender their policies or allow them to lapse—or for people whose life insurance needs have changed. But they are not for everyone. Life settlements can have high transaction costs and unintended consequences—including the inability to purchase a new insurance policy, potential loss of state or federal benefits such as Medicaid. In many cases, you will have to pay taxes on the lump sum you receive.
In addition, be aware that whoever buys your policy will have access to a great deal of personal information about you, including your health status. After all, the buyer is acquiring a financial interest in your death. In addition to paying you a lump sum for your policy, the buyer agrees to pay any additional premiums that might be required to support the cost of the policy for as long as you live. In exchange, the buyer will receive the death benefit when you die.
If a need for cash is driving your decision to consider a life settlement, be aware that surrendering your life insurance policy for its cash value or pursuing a life settlement may not be your only options—especially if you would ideally like to retain your coverage. You might be able to borrow against your policy or be eligible for accelerated death benefits, which allow an individual with a long-term, catastrophic, or terminal illness to receive benefits on his or her policy prior to dying.
For more information on life settlements and how to take each of these steps, read our Investor Alert entitled Seniors Beware: What You Should Know About Life Settlements.
The sting of the recent sub-prime mortgage crisis extends not only to Wall Street, but also to Main Street. An estimated 2 million homeowners stand to have foreclosure proceedings initiated against them in 2008, up from approximately 1.5 million in 2007. Borrowers who can no longer afford to pay their mortgages when the low, teaser rates adjust to higher levels have a limited set of choices: sell, refinance, seek a modification from the lender, or face foreclosure. But, in an area with depressed housing values, the former two options might not be available. As a result, some homeowners who are upside down in their houses—owing more on their mortgages than their house is worth—are simply walking away, wreaking further havoc on their credit profiles and their financial futures. If you do not have equity in your house, be sure to contact your lender before allowing your mortgage to default. You may be able to obtain a modification of your loan terms or develop a workable repayment plan. For help, contact a HUD-approved Housing Counseling Agency.
If you do have equity in your home and are over the age of 60, you might have heard about reverse mortgages. Like a home equity loan, a reverse mortgage allows you to convert your home equity to cash that you can use for any purpose. Unlike other home loans, however, homeowners make no interest or principal payments during the life of loan. The interest is added to the principal, which is why reverse mortgages are often called "rising debt" loans.
Because home equity is often a homeowner's most valuable asset, and most precious source of retirement security, a reverse mortgage is a very serious decision. For many borrowers, choosing one is a last resort way to secure additional monthly income in retirement. Whether the decision is right for you may ultimately depend on a number of factors—your health, your spouse's health, other sources of income, the reason you're tapping your home equity, when you do it, and how wisely you use your loan proceeds.
You will also want to be aware of the broader financial impact of your decision:
The bottom line is that reverse mortgages are an expensive option that may prematurely deplete your home equity. Before you consider one, be sure to weigh all your options—including selling your house (and then downsizing or renting while carefully investing the sale proceeds), taking out a home equity loan, consolidating your debt to reduce expenses or seeking help from your children or other heirs. Also, be sure to look into any local government assistance programs that may provide less risky, or lower cost, ways to address your needs.
For more information about reverse mortgages, please see our Investor Alert entitled Reverse Mortgages: Avoiding a Reversal of Fortune.
Tiding Over a Temporary Setback or Delaying the Inevitable?
If current economic conditions have led you to borrow more than usual—or to consider tapping assets you wouldn't otherwise touch—you need to ask yourself tough questions: Have I taken on a manageable obligation that fits within my budget? Or have I put off for one more day (or month or year) the inevitable day of reckoning? The trouble with putting off until tomorrow the debt you should pay down today is that you're inviting the power of compounding to work against you—and you may be perpetuating an endless cycle of debt.
Saving and investing are essential to financial security. If you are spending all your income (or worse, spending more than you make by running up debt) and never have money to put away, you'll need to find ways to reduce your expenses or make additional money. Here are some steps to consider:
Minimum or More?
Paying only the minimum balance due each month can land you in a perpetual cycle of debt. For example, let's say you have a $3,000 balance on a credit card that charges 18% APR and requires a minimum payment of 2.5% each month. Assuming you charge nothing else, it will take you 263 months—nearly 22 years—to pay off your debt. In addition, the total amount you pay for that $3,000 charge will be $4,115.44.
Weathering rough economic times can prove challenging for many investors. But staying the course nearly always pays off in the long run—and that means taking a long-term approach to investing and making sure you maintain a diversified portfolio that spreads your risk of losses. If strapped for cash, be sure to carefully consider the long-term consequences of quick cash, especially the tax implications of your decisions and the potential for losing a significant asset.