Where to Turn for Emergency Cash
We rank consumers' options, from best to worst.
Even some financially secure households have been hit hard by the current economic and market downturn. But the convergence has been a nightmare for consumers who were on shaky financial footing to begin with. As a result, an increasing number of individuals are maxing out credit cards, tapping their 401(k) plans, and taking out reverse mortgages just to make ends meet.
Some of these options are decidedly better than others. So, if you find yourself in a similar financial pinch--bills to pay but no available cash to do so--it's worth taking a moment to assess your options.
Here's a discussion of some of the options available for those in need of emergency cash. Although individuals' own circumstances will affect the attractiveness of these sources of financing, I've ranked them from the ones that are generally the most palatable to the least attractive.
1. Your Own Emergency Fund/Short-Term Securities
I know, the premise of this article is that an individual doesn't have a rainy-day fund. But no article about financial emergencies would be complete without emphasizing the importance of amassing such a fund to cover unforeseen expenses. If you're aiming to get your financial house in order, putting your emergency fund in place is job one (after you pay off any debt, that is). And if you have an emergency fund, remember: This money is to be used only in true emergencies (when the only alternatives are to go into debt or tap your longer-term investments).
Your emergency fund should consist of highly liquid securities, such as CDs or a money market account or fund. (Beware of higher-yielding money market alternatives, some of which blew up in 2008.) Traditional financial-planning wisdom holds that your emergency fund should be large enough to cover three to six months' worth of expenses. However, I think current economic conditions warrant amassing an emergency fund consisting of a year's worth of living expenses, if you can swing it. (I don't know about you, but if I lost my job I'd rather have more than three to six months to find a new one.)
2. Longer-Term Assets in Taxable Accounts
If you've depleted your emergency fund (or never had one to begin with) and still need cash, your next step should be to turn to any taxable stocks, stock funds, bonds, or bond funds. Remember, though, if you're selling a mutual fund you have owned for a very short period of time, you may face a redemption fee when you sell.
3. Roth IRA
It's never a great idea to tap your retirement assets unless you absolutely need to, but the Roth IRA does offer more flexibility than a traditional IRA, and that flexibility can come in handy if you find yourself in a financial bind.
You can withdraw any Roth IRA contributions (the amount you put in, not investment earnings) at any time, without having to pay penalties or tax. (After all, you contribute aftertax dollars to a Roth, so you've already paid taxes on that money.)
Withdrawals from Roth earnings, by contrast, may be subject to taxes and penalties unless you're age 59 1/2 or meet certain other criteria.
4. 401(k) Loan
Companies are making it pretty easy to borrow from their 401(k) plans--maybe too easy, in my opinion. Some have gone so far as to offer debit cards that allow those who have already applied for loans to tap their savings.
It's easy to see the appeal. You're required to pay the loan back--usually within five years--with interest, but the interest gets paid back into your account, not to a bank. The interest rates can be reasonable, often a few percentage points above the prime rate.
On the downside, borrowing from your 401(k) plan short shrifts your retirement savings. Not only will you have less money working for you in the market, but having to pay the loan back with interest also means that you're less likely to be able to make new contributions to your account. Loans from your 401(k) are particularly perilous if you lose your job. If that happens, you'll be required to pay the loan back right away, usually in 90 days. If you've sunk that borrowed money into some other asset, you'll really be stuck.
5. Home Equity Line of Credit
Tapping your own assets is invariably a better way to scare up cash than borrowing from someone else. But if you find that you must take out a loan, using a home equity line of credit is one of the better ways to go about it. Essentially, you're borrowing against any equity you've built up in your house.
On the plus side, interest rates on HELOCs may be reasonable, particularly if you've got a good credit rating, a fair amount of equity in your home (which also makes it less likely that you'll default), and aren't taking out a huge loan. The biggest advantage to the HELOC versus other loans, however, is that all or part of your interest will be tax-deductible. For these reasons, I recommend that nearly all homeowners secure a home equity line of credit while they're employed and can negotiate terms that are favorable to them. Even if you never need to use it, it's a good safety net in case of emergencies.
On the downside, lenders are feeling quite risk-averse these days, so if you're not a perfect borrower, you could be asked to pay an unfavorably high interest rate. And while it's less likely today than it was a few years ago, there's also the possibility that you could end up borrowing more than you actually have equity in the house; should you need to sell in a hurry, you'd have to cough up the difference.
6. Traditional IRA
Traditional IRAs, as I noted above, offer less flexibility than do Roth IRAs. Unless you fit certain criteria, you'll owe taxes and/or a 10% penalty if you need to take an early withdrawal from a traditional IRA if you've made deductible contributions. Unlike the Roth, you've not yet paid taxes on these contributions, so it only makes sense that you'd owe Uncle Sam when you pull the money out. If you've made nondeductible IRA contributions, you'll owe the 10% penalty and tax on any investment earnings if you take an early withdrawal, unless you fit certain criteria.
7. Reverse Mortgage
Reverse mortgages have become popular over the past decade, as many seniors have found themselves short of income but long on home equity. A reverse mortgage allows a homeowner (usually those over age 62) to receive a pool of assets that represents one's equity in the home. The homeowners don't have to repay the loan as long as they're in their homes, but when they do leave their homes, the borrowed amount, plus interest, is deducted from the home's value.
As reverse mortgages have gotten more popular, they've prompted greater scrutiny and many more reputable lenders have gotten into the business. Still, rates can vary widely, so if such a loan appeals to you, you'll need to shop around. Also, it pays to understand the various types of reverse mortgages. For a good overview, visit the Federal Trade Commission's Web site.
8. Credit Cards
This option is pretty straightforward, and usually not a great idea for reasons that most consumers well understand. True, some consumers have been able to play credit cards like a fiddle, shifting balances among cards with ultralow teaser rates and incurring little in interest along the way. If that's you, more power to you. For the rest of the world, credit cards are the single easiest way to wreck your financial standing. Not only are rates high, but credit card companies have every incentive to keep you paying for as long as possible. Thus, the minimum payments they require don't make a dent in your loan's principal.
9. 401(k) Withdrawal
Most companies will let employees under age 59 1/2 take a withdrawal from their 401(k) plan if they have exhausted all other sources of financing and have an extreme need--for example, to pay unreimbursed medical expenses or to keep their home from going into foreclosure. However, such a withdrawal comes with some major strings attached. Depending on your circumstances, you'll have to pay income tax on the withdrawal and you may also incur a 10% early distribution penalty. And while you don't have to pay that money back (unlike a 401(k) loan), by not doing so you heighten the risk of falling short in retirement. In short, think of this option as strictly a last resort.
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