Have you faced a situation where no matter what you cut in your budget you are still short on cash each month? Maybe your shortfall is just temporary until a promotion, bonus, new job, or additional hours come along.
How do you navigate the situation without digging a hole (where interest is the shovel digging more of a hole without you)?
First: You need a timeline - you need to know how long the shortfall should last. If you do not, then it may be time for a more drastic change (such as changing jobs, moving, etc.).
For example, you know you'll get a bonus at the beginning of the year, receive a promotion within 12 months, overtime hours will be available during the holiday season, or your spouse will change jobs for higher pay, etc.
Once a timeline has been established, then you can start evaluating your options.
Now, let's include an example to help brainstorm some ways to help with your shortfall. This is of course for educational purposes, and not financial advice. This example is based on the fact you have reviewed all of your expenses and done what you can to lower your budget within reason.
Estimated Timeline: 15 Months
Shortfall: $700/month
Estimated Total Shortfall: $10,500 (15 x $700)
Typical options (in no particular order):
Savings
Credit Cards
Personal Loan
HELOC
401(k) Loan
401(k)/IRA Withdrawal
Extra Tips That Can Help
I rule out payday and car title loans as an option.
Savings: If you have a good savings, then many people would say just use your savings. However, your savings is for emergencies, not just for temporary shortfalls. You want to increase your financial flexibility as much as possible. That means keeping your savings intact for as long as possible. You may have a shortfall, but what if an emergency happens? You lose your job, you get in an accident, your AC stops working, your wallet is stolen, etc. The savings helps with emergencies and can act as a backup to shortfalls after Plan A or Plan B. In addition, interest rates on savings is around 4.75% right now which means the longer you keep your savings intact then the more your savings can help. $10,000 @ 4.75% APR = ~$40/month.
401(k)/IRA Early Withdrawal
Rarely is this ever a recommendation and that is because of the taxes you have to pay in addition to the 10% Penalty.
Yes, you receive the $10,500 that you need over the next 15 months, but you pay a lot in taxes.
In fact, based on a marginal federal income tax rate of 12% + 4.5% (state income tax; varies based on your state) + 10% penalty = 26.5%! This is due at tax time, except that 20% is required to be withheld federally at the time you withdraw the 401(k)/IRA.
So if you need $10,500, then you'll need to actually withdraw $14,285 with 20% of that being withheld at the time of withdrawal ($2,857) for federal income tax. Then an additional $928 needing to be paid come tax season.
The main number to focus on is how much you pay to get $10,500 over the course of 15 months. A 401(k)/IRA Early Withdrawal total is $14,285 to get $10,500, even if it means technically not 'going into debt.'
Another way to look at is ~29% APR interest over the course of the 15 months.
For more information about Early Withdrawals from your 401(k)/IRA see my E-book:
401(k) Loan
This can only be done with your current employer. It cannot be done with an IRA or Old 401(k). There are also limits on your loan.
Typically the interest rate is Prime + 1%-2% which right now is around 10%. However, the interest you pay goes back into your 401(k) account. So you keep the interest! Your repayment (principal + interest) does not count as tax deductible. And yes, when you take out your 401(k) in the future, all of that repayment will still be taxed (if it was from pre-tax contributions).
You can only take out 50% or less of your 401(k) balance. So if you have $20k in your 401(k) balance then you can only take out $10k or less as a loan.
Your repayment will be taken out of your paycheck and will be based on a 5 year repayment term or less AND must be equal payments.
Essentially, you take out $10,500 from your 401(k) as a loan (assuming you have a balance greater than $21,000) and your payment will be around $223 or more. This means you'll then have a shortfall of your repayment so you need to take out more than the $10,500 to account for the repayment.
You are also giving up the opportunity cost for that money to grow over the next 15 months or longer.
Though it's a sunk cost, you are tapping into retirement savings that took you the past few years to build up which can feel like taking a step back.
To get $10,500, you will need a $15,500 loan. Your monthly payment (based on 10% interest and 5 year term) would be $329.33 which is taken out of your paycheck which then affects your shortfall which is why you need to take out $15,500. You then actually need $1,029.33/month ($700+$329.33) to cover your shortfall.
The good thing is all of that is still your money: the interest and payments all go back to your into your 401(k).
It is important to know that if you leave your job or are let go, then you have to pay that 401(k) loan back typically within 60 days or it counts as an Early 401(k) Withdrawal and you'll be hit with taxes and the 10% penalty.
For additional information see the article: Your 401(k) - Withdrawals, Taxes, and More
Credit Cards
There are potentially two ways to fund your shortfall with credit cards.
1st: You apply for a new 0% interest credit card for 15 months and you receive a credit limit of $10,500 or higher.
You probably will need a decent credit score to be approved AND to get the credit limit you need.
You will need to make sure you can pay your $700 shortfall with the credit card. You typically cannot pay all of your bills with a credit card so you'll need to make sure incorporating a credit card to fund your shortfall will work.
You will then have a monthly payment which is likely around 1-2% of the balance. In this example, we will say your payment is $110/month which will have to be paid from your checking account. This adds to your shortfall so you will actually need a higher credit limit, say of $12,150 to be able to break even each month.
Let me make this clearer: each month you have your $700 shortfall. But with the credit card payment you'll need an additional $110 paid out of your checking account. That means you'll need to be spending $810/month on the credit card while paying it down by around $110/month.
At the end of the 15 months your balance should be around $10,500.
Don't forget, with the right card, you could be getting 1-5% credit card rewards for your purchases. You can use the rewards as cash back to help lower your balance. That could be cash rewards worth ~$105 or more!
You have to be careful. The $10,500 then has to be paid off by the end of the 15 months or retroactive interest could be applied to the entire $10,500 (or whatever the balance is after 15 months)! That would not be good since it would be $10,500 (or the balance) multiplied by a higher interest rate (ex. 25%) = $3,281!
So you pay off the card through savings or potentially a new 0% interest credit card with a balance transfer fee between 3-5%. The 0% interest could be another 12-18 months. Essentially, this strategy is kicking the can down the road longer, but hopefully your new job, promotion, bonus, or spouse's earnings can help pay it off.
There are also ways to use multiple credit cards for a period of a few months to avoid interest accruing. See the article: Kicking The Credit Card Can Down The Road
That brings us to the 2nd Option: Balance Transfer 0% Interest Credit Card
Let's say your credit score is low or you've tried and you can't get a new 0% interest credit card for 15 months with a $12k+ credit limit...
Well, look at your current credit cards (between you, and if you are married, your spouse). Some companies will send you checks that you can cash (with a transfer fee)! Or others will give you a promotional offer to use the credit card to pay off another credit card balance or other type of debt (student loans, auto loan, etc.).
It can get a bit complicated, but the key is looking among all your credit cards to see if there are any balance transfer options with a 0% interest for 15 months. Some companies charge a 3% fee while others charge a 4 or 5% fee.
I have found that typically it has been Chase that sends out the checks, likely other credit card companies too. Those would be most valuable because you can cash the check in your checking account (it comes with the balance transfer fee), but then you just need to make the monthly payments and of course have a good plan!
I won't dive into additional details, but it's important to keep an eye on this as credit cards constantly send these type of promotional offers through the mail to you or through their app.
You won't get any credit card rewards for the balance transfer. You'll still need to have a backup plan once the 15 months are over. Without a backup plan, then you risk potential retroactive interest on the balance after the 15 months.
Personal Loan
This will require applying online or at a local bank or credit union. Typically, it appears credit unions have better rates and terms, but you always want to double check with two or three lenders before making a decision. Loans are usually around 3 years with interest rates around 12% or higher (right now).
In our example it would be more preferable to have a longer term, depending on the interest rate.
A loan of $10,500 to cover the shortfall is, as mentioned before, not enough because of the monthly payment. In this case at 12.24% interest for a 3 year loan the payment would be $350. To cover the shortfall and the payment you would need a loan of $21,000! The payment would be $700/month. Oddly enough, you would start with $21,000 in your checking account (from the loan), paying $700/month towards the loan from the loan, and $700 from the loan to cover the shortfall. After 15 months you should no longer have the $700/month shortfall and therefore be able to (ideally) make extra payments towards the loan to pay it off quicker and reduce the interest paid.
You'll have paid about $3,230 in interest over the period of 15 months. So you would pay more interest if you can't pay it off right away.
You will qualify for the loan based on your income and credit score. The worse your credit score or tighter your debt-to-income, then your interest rate will be higher. Each lender has different requirements, terms, and rates.
HELOC
This stands for Home Equity Line of Credit. Think of it as a big credit card with lower interest, but uses the equity in your home as collateral. For example, if you have a $500,000 home then you can look at a line of credit based on a 80% Loan to Value. $500,000 x 80% = $400,000. You have to subtract out your mortgage $350,000 to see what potential line of credit you can get: $50,000.
Then you have to qualify based on the HELOC lenders rates and terms. The better terms I have seen are no annual fee and no appraisal fee to have a HELOC. Then the interest rate is based on Prime (a variable rate), currently at 8.5%. Your minimum payment is interest only for up to 10 years. After the 10 years, then it turns into a 20 year mortgage.
Each month, your shortfall would be covered by the HELOC. Instead of paying interest on the entire $10,500 (cumulative shortfall), then you would only pay interest on the accumulating interest each month.
That total interest would be ~$521 unless the Prime interest rate increases or decreases over that time (based on the Federal Reserve). The highest monthly payment would be likely be just over $70 (if interest rates stayed the same).
So the HELOC can be a great option to smooth out the shortfall and pay less in interest, but it does come at a bit of work in getting qualified. It also typically takes almost a month to get the HELOC set up.
You can read more about HELOCs and home equity in this article: Home Equity | HELOC
As you can see, there is no perfect option. But there are multiple options to help reduce the taxes/interest that you pay as well as reduce your stress.
Here's a Quick Review:
Credit Cards (Potentially Lowest Cost): You could end up paying the lowest costs (interest/taxes) or none at all plus cash back rewards on purchases. Monthly payments are smaller, but the risk is not being able to pay it in full after the promotional 0% interest period and facing potential retroactive interest!
HELOC (Most Flexible): Interest is higher right now, but it allows flexibility long-term so you don't face the 15 month interest cliff like you do with a credit card. The interest is less than the taxes you pay with a 401(k). The interest is likely less than a personal loan. But it requires you have equity in your home and qualify based on your credit score and income.
Personal Loan: This option is right in the middle. It doesn't cost as much as taxes on a 401(k) withdrawal, but it's likely more interest than credit cards or the HELOC option. With a shorter term it requires a larger loan to cover the payments. You also have to qualify which means you could be rejected or facing worse terms and interest rates.
401(k) Loan: This depends on your current 401(k) balance and if 50% is enough to help with your shortfall. It's important to recognize the opportunity cost of taking out the loan as well as the risk in the event you lose your job. The interest is essentially a post-tax contribution since it goes back into your account, but the loan payment will be high which means you have to take out an even larger loan to cover the shortfall and the payment.
401(k)/IRA Early Withdrawal: What certainly feels more permanent is taking out the 401(k)/IRA which creates taxes based on your financial situation, but you also always have to add in the 10% federal tax penalty. For most individuals and families this will cost them 26.5% in tax or more. That's essentially credit card interest rate territory! You also face the opportunity growth of your 401(k)/IRA similar to the 401(k) loan, but you cannot pay it back.
The extra things that can go a long way:
Review your current debts and ask your creditors for more time to repay them or ways you may be able to redo payments so that you have a smaller payment and thus a smaller shortfall. Just be sure that it makes sense based on the interest you are paying.
Review your insurance premiums, retirement contributions, or other monthly payments to see if any changes can be made (within reason). For example, if you are currently contributing to your 401(k), then maybe it makes sense for 15 months to put that contribution on hold.
Note that if you receive a 401(k) match, then you should take that into consideration. That is money you are giving up. For example, a monthly contribution of $200 with a match of $200. To stop that would miss out on $3,000 worth of 401(k) matching contributions! It adds up and all costs are relevant. Some costs are long-term while others are short-term.
One idea could be to rollover an old IRA into your current 401(k) which may help if a 401(k) loan works in your best interest.
Strategizing with your spouse - your credit score and credit utilization will likely be different than your spouse. This can impact what type of loans or credit cards you apply for and in what name.
Student loans - they have received a lot of negative publicity recently, but if they are an option in your situation (obtaining a degree) then you should consider and compare them to the options above.
Finally, one option might not work completely for you. You may need to incorporate multiple ways to cover your shortfall. The purpose of all these explanations is to do so in the most efficient way possible.
Wow, that's a lot to go through! Congratulations if you made it to the end of this article. This is a glimpse of what goes on in my head as I help others through financial planning. It's usually not right or wrong or should or shouldn't decision making. I am focused on what makes the most sense for each unique situation. Not only, what will cost you less, but also taking into account what will decrease your stress and lead to a more simple and refreshed financial life!
Blake Jones
(385) 398-4015
PomegranateFinancial.com
Blake@PomegranateFinancial.com
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