Barbara O’Neill, Ph.D., CFP®, Rutgers Cooperative Extension, oneill@aesop.rutgers.edu
The How to Get Out of Debt and Repair Your Credit fact sheet discussed five common strategies for getting out of debt: credit counseling, debt-consolidation loans, fold-down (a.k.a., PowerPay) plans, refinancing/balance transfers, and voluntary surrender. Another frequently-used debt reduction strategy is bankruptcy, which is discussed in the fact sheet "Bankruptcy: A Last Resort." A third debt repayment option may be to access available financial resources as a source of cash to repay debts. Nine specific strategies are discussed below:
Borrowing Against Cash Value Life Insurance
If you own a life insurance policy that has accumulated cash value (e.g., universal life, variable life, and whole life), you may be able to borrow up to 90% of its cash value. Term life insurance, on the other hand, does not include a savings component so loans are not possible. Two advantages of obtaining a life insurance policy-based loan are that interest rates are generally attractive and no credit check is required. A major disadvantage is that the face value of the insurance policy is reduced by the outstanding loan balance if the policyholder dies before the loan is repaid (e.g., $100,000 face amount - $30,000 outstanding loan = $70,000 of available insurance). Still, borrowing against life insurance might make sense for those who have owned a policy for many years and accumulated significant cash value. In addition to having more money available to borrow against, their children may be grown and their need for life insurance reduced. To learn more, read the “fine print” of your insurance policy or check with your life insurance agent or insurance company.
Borrowing Money from Family and/or Friends Borrowing from people that you know is dicey. There is always a chance that the loan will negatively affect your relationship. For this reason, financial experts strongly recommend treating loans from family and/or friends as “seriously” as those from a bank. If someone agrees to lend you money to repay your debts, draw up a contract and specify the amount and frequency of repayment. Be very clear about whether the money is a loan, a gift, or an “advance” on an inheritance. Advantages of borrowing from friends and family: the interest rate charged will likely be lower than rates charged on loans from other sources; there won’t be any late fees and penalties; and there is more “flexibility” and understanding about short delays in payment. Key considerations are whether the borrower is capable of repaying the loan, whether the lender can truly afford it, and whether the loan will improve the borrower’s financial situation or simply delay the inevitable (i.e., bankruptcy).
Borrowing Money from Tax-Deferred Retirement Savings Accounts A tax-deferred retirement savings account (e.g., 401(k), 403(b), and 457 plans) can be another source of cash for repaying debt. Plan participants can generally borrow up to 50% of their vested account balance, up to a maximum of $50,000. Like loans against life insurance policies, no credit check is required and the interest rates charged are attractive, generally 1% to 2% above the prime rate. Loans used to pay for everything except a home, including outstanding debt, must be repaid within five years and made in roughly equal installments. A downside to borrowing money from retirement savings plans is that workers lose the earnings on money that was borrowed, as well as compound interest on this money. In addition, if they are laid off, quit, or are fired, the loan may be due immediately at a time when they can least afford to pay it back. Employer retirement plans rarely allow former employees to continue paying off retirement savings account loans. If the loan cannot be repaid, it will be treated as a withdrawal and a 10% penalty and income taxes will be due.
Government and Non-Profit Agency Assistance Government and non-profit agencies don’t give people money to repay debt. However, they may be able to provide cash benefits and/or services that can free up money in the family budget with which to make debt payments. Examples include public assistance (known as TANF), food banks, SNAP (food stamps), disability benefits, energy/heating assistance, rental assistance, Supplemental Security Income or SSI, veteran’s benefits, and unemployment compensation. With the exception of payments to unemployed workers, benefits are generally based on income, assets, or both. Eligibility criteria vary from program to program. Don’t assume that you don’t qualify for benefits from one program simply because you don’t qualify for another.
Pawnshops When you need quick cash for emergencies or to repay debts, it is possible to obtain money from a pawnbroker if you have something of value to pawn. The broker will require borrowers to surrender the possession until they can pay back the loan. If borrowers pay back the loan plus interest within the designated time period, they get their merchandise back. If they do not pay back the loan and interest, the pawnshop will keep the item, then turn around and offer it for sale at a higher price than the amount of the loan. Pawnshops make money by charging borrowers interest and by selling pawned items for more than the amount loaned. Two advantages of pawnshop loans are fast approvals and the fact that no credit checks are needed. A disadvantage of pawnshops is the high cost of loans, which are regulated on a state-to-state basis. Debtors may get less money for items than they would through a garage sale, Internet auction, and/or newspaper advertisement. In addition, average loan size is small, usually around $50 to $100, so the amount of cash that can be raised at pawnshops to repay debt is limited.
Reverse Mortgages Older homeowners may be able to tap their home equity as a source of cash to repay debt. A reverse mortgage gives older adults the ability to remain in their homes while receiving cash based on their home equity. The homeowner must be 62 years of age or older and the home must be their principal residence. Any existing mortgage must be paid off at the time of the loan or from money received from the reverse mortgage. There is no minimum credit score or income requirement to qualify for a reverse mortgage and borrowers can use the money for whatever purpose they choose. With their home as collateral, borrowers can receive money from the loan as a lump sum, in cash installments, as a line of credit, or any combination of these options. The amount received is based primarily on their age, the value of the home, and the amount of equity in the home. No monthly mortgage payments are required. Reverse mortgages do not have to be repaid until the borrower leaves or sells the home or passes away. At that point, the loan is repaid with interest and the borrowers’ heirs can keep any remaining money. Reverse mortgages are complicated and have high up-front fees which can be bundled into the loan itself. Two good sources of additional information can be found at the National Reverse Mortgage Lenders Association www.nrmla.org and AARP www.aarp.org/money/revmort.
Roth IRA Withdrawals Roth IRAs are funded with after-tax dollars (i.e., money that has been taxed before deposits are made). Therefore, Roth IRA account owners younger than age 59½ can withdraw their contributions to a Roth IRA without incurring a 10% early distribution penalty. Premature withdrawal of Roth IRA earnings, however, is subject to the penalty. Withdrawals are tax-free after age 59½ for accounts that are open at least five years.
Selling Valuable Property With pawnshop loans, borrowers receive cash with the hope that they can pay off the loan and get their items of value back. Another option is to sell valuable assets and use the cash to repay debt. The most valuable items to sell are typically a house and a car. Thus, this strategy usually involves “trading down” to a less expensive place to live and car to drive. Other valuable items, such as jewelry, art, and electronic equipment, can be sold to raise cash.
Withdrawing Money from Tax-Deferred Retirement Savings Accounts As noted above, workers can borrow money from tax-deferred employer retirement savings plans. It is also possible to make account withdrawals, although there are serious downsides to doing so. A 10% penalty, as well as ordinary income taxes, will be charged by the IRS, which will seriously erode the amount of available cash. There may be times when this strategy is necessary, however, such as withdrawing money from a 401(k) to avoid foreclosure.
