Financial Litearcy - Smart borrowing
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401(k) loans versus personal loans

Unexpected emergencies often prompt consumers to look for quick cash to bail them out of trouble.

tapping your 401(k) plan reveals the folly of doing so.

Personal loans can be either be unsecured or secured with collateral. Secured personal loans will get you lower rates. Interest rates for unsecured personal loans are among the highest for popular loan products, hovering around 14 percent over the last year, according to Bankrate data.

With interest rates on personal loans so high, it's important to shop around for the best rates.

"Learn how to negotiate and don't just stop at your neighborhood branch," says Rita Cheng, CFP, a financial adviser at Ameriprise Financial Services in Bethesda, Md.

Credit unions are a good place to start because they tend to offer good interest rates, she says.

If you go to a credit union for a personal loan, you may want to consider getting a share-secured loan that is secured by a savings account. If you maintain a certain balance, you may qualify for lower rates.

Because personal loans often come with costly fees and interest, you might consider borrowing against your 401(k) account, if your plan allows it.

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Many people are under the impression that borrowing against your 401(k) account is relatively risk free.

"People will say if they have to pay back the loan, they are paying interest back to themselves, which may be true," says John Pallaria, Certified Financial Planner and adjunct faculty member in Boston University's CFP Program. "But if they are paying back 6 percent interest and their (mutual) funds are doing 8 (percent), 9 (percent) or 10 percent, there's lost opportunity because the money is out of the plan and not being invested."

401(k) loans versus personal loans
401(k) loansPersonal loans
Pros
  • No credit check or loan application.
  • You're paying yourself back rather than a bank, and the interest rate is lower than with personal loans.
  • Does not affect retirement.
  • Credit union rates can be reasonable, if not low.
Cons
  • Can jeopardize retirement -- The money you remove from a 401(k) is no longer available to invest and cannot generate compound returns.
  • Repaid in after-tax dollars, which are then taxed again at retirement.
  • If younger than 59½, you pay a 10 percent penalty if the loan is not repaid.
  • Not tax deductible.
  • If you quit or lose job, loan must be repaid within 60 days or outstanding balance will be subject to income tax and penalty.
  • Higher interest rate than a 401(k) loan.
  • Not tax-deductible.

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