How payday loans work – biggest dangers and 14 better alternatives (final)

August 8, 2019

14. Borrow from your 401k

Borrowing from your retirement plan is different from making a withdrawal. If you have $50,000 in your plan and you withdraw $5,000, your balance drops to $45,000. The other $5,000 goes into your pocket, you pay taxes on it, and you don’t have to pay it back.

When you take out a loan, by contrast, the balance in your plan stays at $50,000. The $5,000 you took out is still treated as part of your portfolio – it’s just in the form of a loan you’ve made to yourself. However, you have to pay back the $5,000 on schedule to avoid taxes and penalties.

Under the rules of the Internal Revenue Service, you can’t borrow money from an IRA or from any plan that works like an IRA, such as SEP and SIMPLE plans. However, if your employer allows it, you can take out a loan from your 401k or similar plan. You can borrow up to half the balance in your account, up to a maximum of $50,000. And as long as you pay the money back within five years, you owe no taxes and no penalty.

Borrowing from your 401k is one of the quickest and easiest ways to get a loan. You can take up to five years to pay it off, but there’s no penalty for paying it back early. The interest rates are very low – usually around 5 percent. And better yet, all the interest you pay goes into your own account, so it ends up back in your pocket.

However, that doesn’t mean 401k loans are risk-free. The drawbacks of borrowing from your own retirement plan include:

1. Lost earnings. When you take money out of your account, you miss out on all the profits that money could have earned if you’d left it there. If you borrow $1,000 and the market rises by 10 percent before you pay it back, that’s $100 in earnings you’ve missed. Of course, markets can go up as well as down, so you could end up avoiding a $100 loss instead of a $100 gain. But even if you lose money, your lost earnings are almost sure to be less than the cost of a payday loan. Remember, a typical payday loan has an APR of more than 390 percent, which would be nearly impossible to earn invested in the stock market for one year (the average annual return for the S&P 500 has been approximately 11 percent since 1966). And while market gains are hard to predict, the high cost of a payday loan is absolutely certain.

2. Extra fees. The interest you pay on a 401k loan, isn’t really a cost, because it goes right back into your account. But most 401k loans also have an origination fee of around $75. If you’re only borrowing $1,000, that means you lose 7.5 percent of your loan right off the top. In addition, some 401k loans have administration and maintenance fees that last until you pay them back. Again, these fees are much lower than the interest on a payday loan, but they aren’t negligible either.

3. Double taxation. When you donate to a 401k, you use pretax dollars, and you don’t pay tax on the money until you withdraw it. However, when you borrow from a 401k, you have to pay back the loan – including the interest – with after-tax dollars. This means that you get taxed twice on the interest you pay: once when you deposit it, and again when you withdraw it. But this extra tax doesn’t add up to that much money. If you borrow $1,000 and pay it back at 5 percent over one year, the interest is only $50 a year. And if you pay 15 percent in taxes on that $50, your tax hit only amounts to $7.50. That’s trivial compared to the costs of a payday loan, or even a credit card loan.

4. Possible penalties. The biggest risk of a 401k loan is that you absolutely must pay it back on schedule. If you don’t, the unpaid portion of the loan gets treated as a withdrawal. You have to pay the tax on it and the 10 percent early withdrawal penalty if you’re under 59 1/2 years of age. So if you’ve borrowed $1,000 and only paid back $500, you could owe around $125 in taxes and penalties. Fortunately, this type of loan is much easier to pay back on time than a payday loan. You have five whole years to pay it off, and you can pay in manageable installments. You can even have money withheld automatically from your paycheck to make sure you never miss a payment.

5. Switching jobs. If you lose your job or change jobs, you could lose access to your 401k. You can roll over the balance to a new account, but you can’t roll over a loan that isn’t paid off. You have to pay it back at once or else treat it as a withdrawal and pay the tax and penalty on it. However, most employers give you a grace period of 60 days to pay back the loan if this happens. This gives you time to find another source of funds – including any of the ones listed previously – to pay off your loan and avoid the tax hit.

Final word

Payday loans are so terrible that just about any alternative looks good by comparison. Cash advances, overdraft protection, high-interest personal loans, and early IRA withdrawals are all awful ideas under normal circumstances. But if your only alternative is a payday loan, these awful ideas are definitely the lesser of two evils.

However, it’s important to remember that the lesser of two evils is still bad. Other forms of debt are worth using as a last-ditch attempt to avoid a payday loan – but that doesn’t mean you want to become dependent on them.

So once you’ve dealt with your immediate cash crunch, you need to avoid getting into this situation again. Even if better budgeting can’t save you this time around, you should definitely tighten up your budget in the future. At the same time, you should take steps to build up an emergency fund. That way, the next time you’re strapped for cash, you won’t have to choose between bad debt and even worse debt. Have you ever used a payday loan? If so, would you do it again?

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