Chapter 17
Strategies That Can Backfire
In This Chapter
◆ Three questions about any strategy
◆ 401(k) loans: easy access to a bad choice
◆ Signing away your life with debt consolidation
◆ No love for some debt settlements
◆ Don’t mix family and finances
There comes a point when you’re dealing with debt where you feel like you just can’t take it anymore. It feels like another week of phone calls by angry lenders, surprise expenses, and disappointing paychecks will pretty much drive you to the brink of insanity. Those are the weeks when it’s easy to grab for the most convenient and immediate solution, without really caring if it is the best for you in the long run.
Sometimes, the strategies you choose hastily end up robbing your future financial goals. Other times, they solve your immediate problem but immediately wreak havoc on your credit score. Worst of all, they end up being the equivalent of pushing a “financial self-destruct” button that nukes your finances come tax time.
In the midst of your anxiousness to eliminate debt, it’s of the utmost importance that you know how some strategies can come back to haunt you. I’m not saying that you should always avoid them, but you should know the risks and costs up front.
Three Important Questions
When it comes to any debt reduction strategy, there are three questions you need to ask yourself. Even if the strategies you’re considering are different than what I cover in this book, you’ll still be able to evaluate them on your own with these basic questions:
1. What is the long-term cost? In other words, what will you think of this strategy a couple of years from now? Will you be angry that you’re still making payments on some new debt or to a new lender? Will you have to do massive work to make up for a financial goal that you torpedoed to pay off your debt? Would you be able to say, “Yep. I’d totally use that strategy all over again!”
2. What are the short-term costs? Are you paying a lot up front to use this strategy? Will it cost you when tax time rolls around? Will this put you between a rock and a hard place if an emergency comes along?
3. How does it affect your credit score? Is this strategy going to hurt your credit score? If so, how much and for how long?
If you are unsure of the answers to these questions, you need to do more than take a friend or stranger’s word for them. You need to do some research, buy a book, or pay for a professional opinion. Yet more old sayings come to mind: “An ounce of prevention is worth a pound of cure.” Or, as an old carpenter friend used to chide me, “Measure twice so you have to only cut once.”
Dollars and Sense
If you can’t imagine a questionable debt strategy shaving at least six months off the elimination of any one balance, it’s probably not worth the additional risk. As the saying goes, “If it ain’t broke, don’t fix it!”
Even if you are sure of the answers and comfortable with the costs and risks, I would still encourage you to sleep on it for a few weeks. If, after the initial sense of urgency passes, you still feel like it is a good call, then go for it. I’m proud of you for doing your homework and making an educated decision for yourself or your household.
With all that said, here are some of the main strategies to think through carefully before you dive in headfirst. I’ve touched on these in other chapters, but I want to give you the full dose here.
Taking a Loan from Your Retirement Plan
This strategy is so simple and so tempting, which is perhaps why it is used (and backfires) so often. On one hand, you’ve got some large balances you need to pay off. On the other hand, you’ve got a 401(k) with $10,000 to $20,000 sitting in it. One day at the water cooler, the office know-it-all tells you that you should just take a tax-free loan against your 401(k), pay off your debts, and get on with life. He or she also reminds you that you pay interest to yourself, so you’re actually “making money” by doing this.
In the Red
While a 401(k) or retirement plan loan won’t show up as a balance on your credit report, it can still hurt your ability to apply for certain other loans such as a mortgage. This is due to the fact that lenders will include your 401(k) loan payment in the front- and back-end ratios I talked about in Chapter 5. If you think you are going to use another strategy like an auto or home refinancing, you’ll want to hold off doing your 401(k) loan until after those transactions are complete. Doing these loans first will not affect your ability to use a 401(k) loan, because no credit check is required for that.
Borrowing from your 401(k) is one of those strategies that can backfire in a huge way on many levels. Be careful before choosing this option. Here are some 401(k) loan pitfalls you need to consider:
• Taxes. If you quit or are fired while you are still repaying this balance, and you cannot repay it almost immediately, the loan becomes a distribution. This means that the unpaid balance is now added to your income for IRS purposes, which will cost you federal and state income tax plus a 10% early withdrawal penalty. Unfortunately, because this was a loan originally, no withholding was ever done. This means you’ll potentially need to come up with the entire tax due come April 15th. On a $10,000 loan, this can easily translate into $5,000 you’ll pay out-of-pocket to the IRS!
• Your retirement growth stalls. Every 401(k) I’ve run into in my career freezes 100% to 200% of the amount you borrow. This means that an amount equal to your unpaid balance is removed from the investments of your choice and will now only earn the interest that you pay on the account. Of course, it is not really earning interest, but simply putting more of your own money into the account.
• Decreased paychecks. The repayments for your loan come directly from your paycheck and are based on a preset payment schedule. In other words, you have no wiggle room on how much or when your loan gets repaid each month. Your money disappears before it ever makes it into your bank account. For many people, this creates a new financial hardship that tempts them into using credit cards again.
Dollars and Sense
If your company or industry is going through downsizing and a layoff is more likely than in the past, you’ll really want to reconsider that 401(k) loan. If your company gets bought out, however, and you retain your job, there should be no negative tax consequences associated with your 401(k) loan.
Debt Consolidation
While it may be tempting to combine all your debt payments into “one easy payment,” it comes with some immediate and delayed consequences. Before you choose this option, especially with a company that only offers that service, you need to understand the effect on your ability to borrow and the potential for asset seizure:
• Debt consolidation makes a strong statement to the future lenders of your life. It’ll likely raise the level of concern they’ll have about collecting their potential loan payments from you. In essence, when a potential lender looks at your credit report and sees all your balances moving to a consolidation, it seems to prove that you can’t handle the responsibility of a loan.
• For debt consolidation companies to justify the risk of taking on people who are not currently making their payments, they need to have some pretty strong resources as far as collecting their money. Hence, they’ll often make you sign a paper giving them broad powers to seize your assets to pay off your debts if you fail to pay. By consolidating, you go from working with multiple lenders who have minimal collection powers, to one lender who can take the shirt off your back.
In the Red
Getting a car or other items repossessed can add to the weight of your debt load. Unlike a mortgage, which is often set up as nonrecourse debt, you are generally on the hook for the difference between what your bank sells a repossessed car for and what you owe. On top of that, the entire cost of a repossession action (usually $300-$500) is passed on to you the consumer. Think carefully before you enter into any agreements with debt consolidators that give them greater repossession rights than what your current lender has.
Debt Settlement
I’ve talked a lot about negotiating a debt settlement throughout the book. For many people on the brink of bankruptcy or collections, this is a great method to get a financial leg up. Unfortunately, not all debt settlements are created equal in terms of how they affect your credit report. Additionally, a debt settlement may suck up what little available cash you have to manage day-to-day expenses.
Many companies that are not in the full-time business of lending money (like hospitals or local businesses) don’t even know how to begin reporting things to the credit reporting agencies. Credit card, mortgage, and auto lending companies, on the other hand, do.
Many times (but not always) a professional lender will report debt settlements on your credit report while other types of businesses do not. Again, looking through the eyes of a potential lender, a debt settlement makes you a scary prospect for a new or cheap loan.
The key concept behind a debt settlement is that you are waving cash in hand in front of your lender. You’re not offering them a payment plan. You’re actually offering them a final payment, albeit less than your balance. You need to ask yourself where that cash will come from and what the effects on your ongoing spending plan will be.
Borrowing from Friends or Family
I mentioned earlier that I’m not a huge fan of borrowing money from friends or family, unless the situation is beyond desperate or you are paying off a payday loan. While friends and family are not likely to gouge you on interest, borrowing money can create significant strain on relationships.
Dollars and Sense
If you’re going to borrow from a family member, consider writing up a contract even if they don’t expect or ask for it. The contract should include the initial amount, the payment amounts, and the final payoff date. Having a contract will help you feel truly accountable to the person you borrowed from, while also helping them to feel like they weren’t taken advantage of.
In fact, just recently I was speaking somewhere on personal finances and a woman came up to me with a helpless look on her face. She had loaned her best friend about $750 six months ago due to a financial hardship. Her friend made a couple payments to her and then stopped.
After a few months, the woman I was talking with called her friend to just see if everything was okay. In fact, she wasn’t even worried about the money, but just her friend. Months, and dozens of calls later, it’s clear that her friend can’t bring herself to call her back. In the end, a friendship may have been destroyed over a relatively small loan and good intentions.
Here are some of the risks to consider in borrowing from a friend or family member:
• You’re putting them on the spot. One of the most important lessons I learned from my mom (which made a big difference in keeping my wife from killing me over the years) was to never put her on the spot. In other words, if I wanted to go spend the night at Jimmy’s house, it was really lousy to ask my mom right in front of Jimmy. Doing so made it harder for her to say no. When you ask someone who cares about you to borrow money, they’re going to have a hard time declining because you matter to them. In the grand scheme of things, that may be a pretty lousy thing to do and may cause someone to resent you for even asking. This may be especially true if you can’t repay it when you promised.
• You’ll owe them. Good friends and family would loan money to you just because they want to help, not because they think you’ll help them out someday. But, realistically, you will owe them the same favor. If that time comes and you aren’t ready to return the favor, it can create some major awkwardness and resentment.
• You may be hurting their financial goals. Borrowing $50 is one thing. Borrowing $5,000 is another. That large of a request may keep some people from making their IRA contribution for the year, taking their dream vacation, or paying down their own debts. If you are going to borrow, consider asking someone who has plenty of cash and has achieved the vast majority of his or her financial goals in life.
Other Strategies to Avoid
Over my years as a financial planner, I’ve pretty much seen it all. Every imaginable way that people can dream up to cut corners on the debt elimination process has been tried. Before you think you’ve discovered a loophole or trick I’ve missed, here are some of the more off-the-wall strategies that I’d recommend against.
Credit Card Checks
There are a number of credit card companies that actually send out two to three blank checks every few months to their account holders. If they are used, the amount you write them for is added to your account. These checks usually come with exorbitant fees and high interest rates, and continue your cycle of using debt. Try to avoid using these to pay off other debts, much less your regular bills.
Tax Refund Loans
Many of the low-cost tax preparation chains offer you the ability to get your tax refund immediately upon filing your return. In reality, they are making you a loan against the refund you’ll receive in just four to six weeks, if you use direct deposit. While the fee may seem small, when you look at the interest rate on an annual basis, it is often over 100%.
Dollars and Sense
The earned income credit (EIC) is money paid to you by the IRS if you are over age 25 and earn less than a certain amount of income. It increases substantially if you have children under 18 years old. Sadly, the IRS doesn’t automatically hand out the EIC, but requires you to file a form with your tax return. Unlike the private tax or refund-anticipation loans that charge exorbitant fees to get your money a few weeks early, you can get a monthly advance on your EIC from the IRS through your employer’s paycheck. To learn more about this program, talk to a professional tax preparer or request IRS Publication 596 from www.irs.gov.
Loans from Pawnshops
Pawnshops are places that will loan you money in exchange for some type of collateral, such as that set of diamond earrings Grandma gave you. Quite simply, you give them the item and they give you some cash. If you don’t repay them within a certain time period (usually 30, 60, or 90 days), they can sell your item. In short, pawnshops are a rip-off. The interest they charge can range from 20% a year to over 100%, not counting all their fees. You’d do better to sell your stuff on eBay, where you’ll likely get a lot more without paying any interest.
Getting Paid Under the Table
It’s hard to not get angry sometimes when you look at your pay stub. The amount of income, payroll, and employment taxes that come out makes it almost feel like work isn’t worth the effort. So when someone gives you the opportunity to get paid “under the table” it’s natural to want to take it.
Here’s the problem. Getting paid in cash and not reporting it on your tax return isn’t just a cool perk of working for some employers. It’s tax fraud and it is a felony. While you might save some significant tax dollars for a few years, there is a good chance it will eventually catch up with you. As prehistoric as the IRS is in so many aspects, its computer system that identifies tax cheats is cutting edge. In addition to steep fines, you could face jail time for hiding even a portion of your income.
Before you report your employer to the IRS for paying you “under the table,” double-check to make sure they aren’t planning on issuing you a Form 1099 at the end of the year. A Form 1099 means your employer is actually reporting your wages, but considers you an independent contractor. This means that all the responsibility is on you to set aside money for taxes and Social Security. If this is your first year receiving a Form 1099, talk to a tax preparer as soon as possible, because the amount you owe can be substantial.
The Least You Need to Know
• If you’re thinking of trying an innovative debt reduction strategy, be sure to consider the short- and long-term risks.
• 401(k) loans backfire on their users as often as not, and should be used with great caution.
• Debt consolidation and debt elimination can keep you from getting new loans and put your assets at risk.
• Borrowing from friends and family may save your finances but significantly damaging your relationships.
• Don’t be hasty to cut corners in your debt elimination plan.
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