Borrowing From Your 401(k) Could Be Hazardous To Your Wealth

Borrowing from your 401(k) plan should be your last resort, not your first. Ideally, you will never touch your retirement funds, allowing them to grow continuously until you retire. But we don't live in an ideal world! With home prices falling and lenders tightening credit, an increasing number of Americans are borrowing money from their 401(k) retirement plans. In the long run, the disadvantages clearly outweigh the advantages.

Taking loans against a 401(k) plan is allowed by law, but an employer is not required by law to allow it. If offered, an employer must adhere to some very strict and detailed guidelines on making and administering a loan. The statutes governing plan loans place no restrictions on what the need or use will be for loans, but an employer can restrict the reasons for loans. Some plans charge fees when you borrow from your 401(k). Plans can charge a one-time fee, a maintenance fee, or a combination or the two.

There are several advantages to a 401(k) loan over other types of loans. A plan participant can borrow up to half of their vested balance, but no more than $50,000. There is no credit check and no qualifying, although you may need a spouse to sign a consent form. You may receive the loan in a matter of days and have up to five years to pay the money back, except when the funds are borrowed for the purchase of a residence, in which case you may have up to 15 years.

You pay interest on the amount borrowed - often the "prime rate" plus one or two percentage points. Interest proceeds then become part of the borrower's plan balance. There is a popular misconception that paying back a plan loan is like paying yourself. While it is true that you are paying yourself interest, when you borrow money from yourself you are simply replacing the interest you would already be receiving from someone else with interest payments from yourself. Paying yourself interest is sound advice when it is an alternative to paying someone else interest, but not as an alternative to receiving interest from someone else.

You repay the loan through automatic payroll deduction with after-tax dollars, plus you lose the compounded interest that you would have received if you had left the money alone because the amount that you borrow is subtracted from the principal balance. You have no flexibility in changing the payment terms of your loan. You also get taxed twice - once when repaying the loan with after-tax dollars, and a second time when the money is withdrawn at retirement.

So, let's say your monthly payment is $300 and you're in a 28% Federal tax bracket. You'll have to make $416 in gross earnings to have enough left after taxes to make the $300 payment. Interest paid on the 401(k) loan is not tax-deductible even if you borrowed the money to purchase a residence.

If you default on a 401(k) loan, you will receive a Form 1099 from the plan because the government considers the defaulted balance a taxable withdrawal. You will be charged Federal and State taxes on the outstanding balance plus a 10% penalty if you are under 59 1/2 years of age.

The biggest disadvantage is the following: If you leave your job, even if it is not your choice to leave, the 401(k) loan comes due and typically must be repaid within 30 to 90 days. If you cannot pay the loan in full you will be charged Federal and State taxes on the outstanding balance plus a 10% penalty if you are under 59 1/2 years of age.

Another disadvantage is the temptation to reduce or eliminate the amount you are contributing to the plan because you now have a loan payment, which will reduce your long term retirement account balance. If you stop contributing while you have an outstanding 401(k) loan, you will also miss out on the company match, provided your company offers a match.

Lastly, when you apply for a mortgage, current lending guidelines state that any 401(k)loan payments will be counted as a debt and included in your debt ratios and any outstanding loans will be subtracted from the your vested 401(k) account value for reserve purposes.

The bottom-line is if you are considering borrowing from your 401(k) make sure you understand the consequences, both good and bad.

Are You Paying Too Much In Property Taxes?

Did you know that over the last eight years, property taxes have actually outpaced even inflation? Those rising taxes – combined with the recent plateau in house values in some areas – means you may be paying more than your fair share.

If you purchased your house or completed construction on your house since 2004, it is possible and very likely that you are paying too much for your property taxes. Some people who purchased in 2003 may even be affected. The current decline in house values is affecting everyone but some areas are affected more than others.

Under Proposition 13, property taxes can be increased annually by no more than 2% to account for increases in your property’s value due to inflation. Shortly after Proposition 13 was passed, Proposition 8 was passed, which allows a temporary reduction in property tax assessments. Under Proposition 8, a temporary reduction in assessed value can be made when the market value falls below the current assessed value. This is an important distinction because the assessed value may not be the same as the market value. Many counties use a formula which uses a percentage of market value to determine assessed value. Your property’s assessed value is shown in the upper right hand corner of your current tax bill as “Net Taxable Value.”

In practical terms, and with the history of real estate appreciation, most assessed values in San Diego County are well below even current market value. Realistically, this will only affect those property owners who purchased their property at the height of the current real estate market.

If you believe your property’s market value has fallen below its current assessed value you should file an Application for Review of Assessment with the Assessor’s Office as soon possible but no later than May 30, 2008. Click here for easy access to the required forms. Submitting an appeal is generally a fairly simple process, but make sure to take the time to fill out all forms in advance and be prepared with your documentation if there is an in-person hearing that needs to take place. My understanding is that due to the high volume of requests the Assessor’s Office will be notifying property owners in early July of the results of their request.

You can mail or drop off the completed forms to the San Diego County Tax Assessor at 1600 Pacific Highway, Room 103, San Diego, CA, 92101.

A word of caution: If you appeal for a lowered assessment and it is determined by the board that the current market value of your property is actually greater than your current assessed value they can increase your property taxes. The bottom-line here is to compare your current market value to the current assessed value on your tax bill to determine if you are even a candidate before you take any action.

Your appeal must be based on the market value of your property as of January 1 of the year in which you are filing. For example, if you file your appeal in 2008, your appeal must be based on the market value of your property as of January 1, 2008. An application must be filed for each year you disagree with the assessor’s value, even if you have a decline in value appeal pending for a prior year.

If you need current comparable sales to your house you are welcome to send me an e-mail to Shawn@YourFavoriteLender.com with the address in question and I will be happy to forward them to you. You may need to submit proof of the decline in value to the assessor along with your request.

If your appeal is successful, the new assessed value will be used to determine your property taxes for the year appealed. The new assessed value of your property, however, does not automatically become the value for the following year. The assessor is required to review your property’s value annually once a decline in value has been determined. He or she will compare your property’s market value with its base year value plus adjustments for inflation. The base year value is the value of your property at the time of the change in ownership from the seller to you or at the completion of construction. The assessor is required to assess your property at the lower of those two values.

According to the National Taxpayers Union, about 33% of property tax appeals succeed! Taking the time to review the accuracy of your tax bill could easily save hundreds of dollars per year, adding up to thousands of dollars during the time that you own your house. Please feel free to contact me at (619)574-6545 for more information on this money-saving tip.

There are numerous private businesses and individuals mailing solicitations to property owners offering their assistance in this process for a fee ranging from $175 to $300. While you are at liberty to use a company if you wish, you can apply for this reduction yourself at no cost by simply filing the application.

The Equity Line of Credit: Safety Net or Web of Deception?

As many of you may have found out recently, a Home Equity Line Of Credit (HELOC) is not the safety net you may have thought it was. Many homeowners with an equity line have received a letter from the lender who holds their HELOC informing them of the following (click on the document to view larger text):

Worse than this is the fact that some lines of credit were completely frozen (click on the document to view larger text).

You are probably asking, how can they do that? Believe it or not, it is in the fine print. My own HELOC agreement states the following (click on the document to view larger text):

The only lines that were reduced or frozen were lines of credit that had an available balance. Lenders wanted to reduce or eliminate homeowners’ access to their equity through their existing equity lines.

Homeowners who had maxed out their HELOCs were not affected by this. Whether they used the HELOC to pay off debt, pay for a remodel project or simply extracted the wealth to protect it and keep it safe and liquid, their lines were left intact because there was nothing to freeze.

Homeowners who had been relying on their HELOCs no longer have access to them. I’ve heard stories of homeowners who were in the middle of a home improvement project and were unable to pay their contractors because they were using their equity line to fund the project. People who were using their equity line as an emergency reserve or fallback plan in the event of a job loss or sudden financial hardship were also adversely affected.

For some of the lenders there is a dispute process but essentially that consists of you paying for a new appraisal ordered through an appraiser that the lender chooses. If the value is determined to have dropped in accordance with the lenders assessment then you are simply out the money. If, however, the appraisal does show the value is higher than what the lender determined it was they still reserve the right to refuse to restore the line of credit to its original amount, which doesn't sound like much of a dispute process, and you are still out the money for the appraisal.

If you are one of the fortunate few that have a HELOC that has not been reduced or frozen you may not want to take a chance that the lender won’t suddenly decide to follow the other lenders that have done just that and send you a letter. I can assure you that it is not typically the kind of news received with a smile. My advice is to look closely at your financial situation and decide whether or not it makes sense for you to borrow the max available to you and put it in a savings account just in case. Yes, I am aware that it comes with a monthly payment but as your equity continues to lose its value wouldn’t it be better to preserve and protect what you have left of it before you end up needing it? Besides, with the Fed lowering rates as they have and will likely continue doing, HELOCs are one of the few instruments positively impacted with a corresponding drop in rate and payment.

In times of uncertainty, one thing is certain. Cash is King!!!

Ric Edelman, author of The Truth About Money says, “A proper financial plan plans for the worst and hopes for the best.” The saying “it’s better to have money and not need it than to need money and not be able to get to it” has never rang so true.

House rich and cash poor is not an option in these changing and trying times. Life happens and you need to be prepared.

The only way to protect your equity and keep it safe is to keep it separated, liquid and accessible. I will talk about profitable equity management in a future article.

Fed Rate Cuts Don’t Necessarily Mean Lower Mortgage Rates

So the Fed cuts rates another 0.75%. Is a Fed rate cut really good news for mortgage rates? The facts may be surprising. The Federal Reserve can only control the Fed Funds Rate and the Discount Rate. The Fed Funds Rate is the rate at which banks can borrow money from one another on an overnight basis. The Discount Rate, on the other hand, is the rate at which banks can borrow money directly from the Fed on an overnight basis (now a 30 day basis). This is very different from mortgage rates.

A mortgage rate can be in effect for 30 years. A rate that is set by the Fed can change from one day to another. This is a counter-intuitive relationship for most people because when they hear that the Fed is lowering rates, they instinctively think it means mortgage rates.

The Federal Reserve uses the Fed Funds Rate and the Discount Rate to both stimulate and slow down the economy. The Fed watches trends in new jobs, new unemployment filings, worker productivity, wages, housing, both resale and new construction, and inflation at the consumer and producer level.

The Federal Reserve is trying to maintain a “healthy” economy. If the economy is growing too fast the Fed will raise rates to slow down economic growth. If the economy is slowing down, as it is currently, the Fed will cut rates, and sometimes aggressively, in an attempt to stimulate economic growth.

So what are mortgage rates based on? The answer is mortgage-backed bonds known as Mortgage-Backed Securities (MBS). How these bonds issued by Fannie Mae and Freddie Mac perform will determine the direction of mortgage rates.

It is not necessarily what the Fed does that affects mortgage rates, it’s how the Nasdaq and the broader stock market interprets the Fed’s action and policy statement that will ultimately influence the direction of mortgage rates. This is because money managers and mutual fund companies typically keep funds in either stocks or bonds with very little in cash. If stocks are in favor, money is pulled from bonds, causing bond prices to drop and interest rates to rise. When stocks are being sold off, the money is then parked into bonds, which improves bond prices and causes interest rates to decline.

If the Fed Funds Rate and mortgage rates were truly related, the chart shown here wouldn’t show them going in opposite directions – all three lines would move in tandem.

Fed rate cuts can fuel inflation, because lower rates just serve to make it more attractive to buy and finance goods and services. If the economy grows too fast, as has been the case for the last five or so years, inflation can become a problem for the consumer (you and me).

The Federal Reserve is doing all it can to keep this country from going into a recession. While the Fed normally seeks a balance between economic growth and inflation, in this case the Fed has essentially decided to sacrifice inflation to save the economy. That is not to say that the Fed is turning a blind eye to inflation. They are just focusing more attention on keeping the economy from slipping into a recession. There is a concern about the possibility of Stagflation. Those who remember Nixon remember Stagflation. This is a situation where the economy stalls and inflation rises simultaneously. In other words, people are losing jobs, making less money, and spending more to buy the basic necessities of life because of inflation.

I wouldn’t want to be Ben Bernanke is these trying times. To summarize, Fed rate cuts do not necessarily equal lower mortgage rates. There are a variety of factors that influence mortgage rates and it is important for people to know that so they don't wait for the next Fed rate cut to refinance or purchase and miss the boat because what they thought to be true turned out not to be.

Want To Be More Conservative With Your Mortgage Financing? Make A Smaller Downpayment!

Equity investments (a.k.a. downpayments) in Real Estate earn a 0% Return On Investment (ROI). Surprised? Well, let's understand the math: Assuming a 5% annual rate of appreciation, a home purchased for $400,000 will appreciate to $420,000 in one year. If the homeowner originally invested $80,000, or 20%, theoretically, the ROI is 25%. This is true because it appears that the initial $80,000 downpayment yielded $20,000 in equity appreciation. However, it is important to note that the $80,000 had nothing to do with the $20,000 appreciation.

If the homeowner had not invested the $80,000, the home would still be worth $420,000 in one year. In this instance, the ROI is infinite because the homeowner invested nothing and yet received the same $20,000 in appreciation. However, we must take into account that the rate of borrowing will be higher in this example because there is no downpayment.

Using a 7.00% Home Equity Line of Credit (HELOC) to finance the $80,000, the payment will be $5,600 in Year 1. The second example yields a return of at least 357% because the $5,600 additional payment yielded the $20,000 in appreciation.

There are other ROI considerations for the homeowner. A home is a non-liquid asset, meaning that once the homebuyer's money is invested in the home, there is a real cost to extracting the money as cash.

The initial $80,000 investment, therefore, is "lost" -- tied up in equity until the homebuyer sells, refinances, or takes out a HELOC.

Not only is the initial $80,000 investment earning 0% return for the homeowner, it is unavailable for other investments which could be earning 2% as a Money Market Mutual Fund, 5% as a Certificate of Deposit, or even higher returns with other instruments.

Therefore, the opportunity cost of making a downpayment is further depleting ROI for homeowners.

A "conservative" person will read this argument and say, "That's too risky. I am too conservative to make small downpayment."

I can buy that argument, but those two sentences are not related at all.

A true "conservative" person will recognize that the smaller the amount of downpayment, the larger the risk that the bank is taking. As the homebuyer's downpayment shrinks, so does his personal exposure.

"What if the property depreciates! Then I'll be exposed!" they'll say next.

That's true, but if the property depreciates, there is no advantage to your initial equity investment anyway. I'm sorry, but Out of sight, Out of mind is no way to manage your equity investments and finances.

The reality is the conservative financing option is to make smaller downpayments. In doing so, you push risk to a third party -- the bank! -- and you remain very liquid.

Liquidity is the true goal of a conservative investor.

I am not arguing against making downpayments on properties, for the record. But, for people who claim that Real Estate is an investment, they should treat it as such. This is consistent with my philosophy that a mortgage should be one component of a larger (managed) financial plan.

The advantages to making an equity investment in property is that the resultant monthly mortgage payment is lower. If a homebuyer's monthly cash flow is low, but their investment capital is high, there is an argument for putting 20% or even more into the property. There is also tremendous psychological inertia to overcome with respect to putting less than 20% into a property. Some people just won't hear it any other way.

That's fine -- different strokes for different folks!

Okay, with all of this said, there is actually a return on the equity investment. That return is the money saved by not paying interest on the higher loan amount if no downpayment is made. That means that the homebuyer saved an amount equal to the interest rate on the loan, or 7.00% in this case. So which is the more conservative strategy; 1) Investing a large downpayment to secure a lower monthly mortgage payment, leaving little money in reserves, or 2) Investing very little or no downpayment, paying a slightly higher monthly mortgage payment and leaving a large reserve to cover the increased payment as well as life's inevitable unscheduled emergencies?