Even before COVID-19, some of us faced financial crises in our lives. Despite our very best efforts, hard work and great planning, we found ourselves faced with a financial catastrophe. Not an “I need to eat ramen noodles for a week in order to make my minimum credit card payment” crisis. (That is a problem, but one of a different sort.) I mean a true, almost existential, emergency. Overwhelming medical debt. Job loss. Death of a loved one. A problem that is not going to right itself with a few weeks or months of sacrifice and buckling down.
And let me add that none of these “black swan” events may have led to your financial crisis. Perhaps you may not have always put in “best efforts” in managing your personal finances. Whatever. Here we are and what are we going to do about it?
Research tells us that humans do not make the best decisions under stress. In a crisis, you are going to need to make immediate decisions to put out the fire. The goal of this series of blogs is not to show you that there is an easy out if you fail to plan for emergencies — just the opposite. “Breaking the glass” has real costs. The goal here is to provide a way to think through the consequences of those immediate decisions with an eye to not making decisions in the heat of battle that are going to possibly make the situation worse down the road.
This is the first of a three-part series. The presumption here is that the immediate crisis you face is that you need money. Not a little, but a lot. What “a lot” is to one person may be trivial to another. Let us say more than you have in your emergency fund savings (assuming that you have such a thing). And you have no choice but to pay this money — to a creditor, to a landlord, to whomever — in a fairly short amount of time.
Let’s review the pros and cons of some options that you may be considering:
Borrowing from your workplace retirement account (401(k), 403(b)
I don’t like it, you don’t like it either. But as I said, this is an emergency, not just a lapse in your budget. The most obvious cost is that money that is not invested in your account is not earning a return and this can risk your future retirement. Further, depending on your employer, you may not be able to make contributions to the account while you are paying back the loan. Do you even have the cash flow to pay back the loan? Loan payments are usually automatically withheld from your paycheck and generally cannot be stopped. If you leave your job and do not pay back the loan immediately, the outstanding loan balance will be treated as a withdrawal subject to income tax in addition to a 10% penalty (assuming you are less than 59 ½ years old). Those are the cons. The pros are that you can access this loan quickly with little fuss, the interest rate is likely to be fairly favorable (and paid by you back into the account).
Hardship withdrawal from your retirement account.
Under limited circumstances, you can make a withdrawal from your workplace traditional or Roth retirement account, or a traditional or Roth IRA account, without penalty. These circumstances are fairly limited, usually large medical expenses or permanent and total disability. (Penalty-free withdrawals for a first-time home purchase or college expenses are outside of the scope of this blog. Also, don’t do that.)
As before, the cost is that you have possibly imperiled your retirement. If you experience a turn of fortune to the good in the future, you cannot replace what was withdrawn; the maximum annual contribution limits will always apply.
Withdrawal from a Roth-type account.
Because contributions to a Roth account (Roth 401(k) or Roth IRA) are made after-tax, you can withdraw your contributions without penalty regardless of your age once the account is at least five years old. Before that anniversary, your withdrawal will be subject to a 10% penalty. Any earnings that you withdraw will always be subject to the 10% penalty, as well as income tax, before you are 59 ½ years old (assuming you are not claiming a hardship). And yes, you are making it that much harder to retire if you make such a withdrawal. How much harder? If you withdraw $10,000 at age 35, you will have set your retirement back by more than $76,000 assuming a reasonable return for the next 30 years.
Home equity loan.
Unlike the options just discussed above, this is not particularly fast and it is certainly not fuss-free. However, borrowing against the equity in your home can be an option when facing a break-the-glass emergency which requires a large sum of money to resolve. However, because you are in an emergency situation, depending on how you got there your credit history may be tarnished. Despite being a loan secured by your home, lenders will consider your credit score. What’s more, if your crisis does not pass fairly quickly and you fall behind on your repayment, you may be adding the loss of the roof over your head to your woes. Borrowing against your home is a heart-attack serious decision. Do not consider this without game-planning for the worst case scenario.
Pay Advance Lenders.
This has become a bit more complicated in the last couple years. I think that we are all aware that the typical storefront payday lender is something to be avoided because of the enormous fees that can (and usually do) accrue. However, some employers are getting into this game by offering their employees advances on their upcoming paycheck for a small fee. (There are also now paycheck advance apps available, which charge a fee for advances.) The obvious downside is that if your problem has been caused by a growing mountain of obligations that is sapping your cash flow, this is not solving any problem and actually making it worse. But for a temporary one-off emergency, an employer advance can be a better option than…
Credit Card Cash Advance.
It’s incredibly expensive (annual interest rates are in the 25% range and there is an additional flat fee of 3% to 5% of the amount borrowed) and realistically it is likely to lead to a worsened situation in very short order when the next credit card statement arrives. If you could not pay your bills in May, why would you be able to pay an even larger bill in June?
The mere fact that title loans — whereby you give the lender your car title in exchange for a short term, high interest loan — are illegal in 30 states should give you a clue that this is a notoriously bad idea.
Part 2 coming on August 10!