These short-term solutions to your money problems can lead to long-term damage
December 9, 2014 – By Geoff Williams
You’re short on cash, but there is something important you need to spend money on, like your mortgage or an electric bill or groceries. So you settle on what’s often called a “Band-Aid” fix. That is, you come up with a very short-term solution that solves your financial dilemma today.
The trouble with Band-Aid fixes is that they sometimes lead to further bleeding and can make your problem much worse. You may feel it’s worth the risk, but it’s still helpful to think through the possible consequences. So in the interest of being aware of potential problems ahead, here are five common Band-Aid fixes to carefully consider before applying.
401(k) loans.
It’s easy to see why some people borrow from their 401(k) if they’re facing a cash shortage or need a cash infusion for, say, a down payment on a home.
“These loans are offered by many corporate-sponsored 401(k) plans at fairly low rates,” says Pam Friedman, a certified financial planner and partner at Silicon Hills Wealth Management in Austin, Texas. She adds that you can generally borrow up to 50 percent of your vested balance or sometimes up to a maximum amount, and these loans let consumers pay themselves back over five years.
“The employee pays the interest to him or herself, which makes 401(k) loans very attractive to employees,” Friedman says.
Why this may not be a good short-term fix: There’s a lot to like about this type of loan, but before you get too excited, Friedman says, “There is a hitch. Actually, more than one.”
She says if you leave the company for another job, the loan you could have taken five years to repay typically needs to be paid back within 60 days or the remaining balance will be considered a withdrawal.
What’s so bad about that? “For most workers, that means the remaining loan balance will be taxed as ordinary income of the employee’s and assessed a 10 percent penalty,” Friedman says.
She adds that even if you repay your 401(k) loan on time, you may reduce your contributions in the meantime, which hurts your retirement savings. “That’s an expensive loan,” she says.
Deferring loan payments.
In this case, you contact your lender and ask permission to stop payments for a period. It’s frequently done with student loans but can also apply to car payments and even mortgages.
Why this may not be a good short-term fix: With student loans, the interest will typically still pile up and be added to the principal, which will stretch the length of your loan.
Your auto lender will usually attach the deferred monthly payment to the end of the loan, so when you reach that point and you’re ready for the loan to be paid off, you may well regret the decision – especially if you deferred multiple payments throughout the life of the loan.
With mortgages, it’s harder to get a deferral. But if you manage to get one and you’re still making monthly private mortgage insurance payments, you will likely prolong the amount of time you’re making those PMI payments, possibly by a couple years.
Payday loans.
If you have a family to feed and next to nothing in your bank account, a payday loan may seem tempting. Payday loan centers aren’t concerned with your credit – they will ask for proof of employment, residency and references. Assuming you pass muster, they’ll give you cold, hard cash.
Why this may not be a good short-term fix: If you think it’s tough getting by on no cash now, wait until you have to pay back the loan. “Unless you have a solid plan to repay this kind of loan quickly, it’s most likely only going to worsen your debt situation,” says Katie Ross, education and development manager at American Consumer Credit Counseling, a financial education nonprofit based in Auburndale, Massachusetts.
According to the Consumer Financial Protection Bureau, the median payday loan amount is $350. The larger your paycheck, the better your odds of paying back the loan, unless you simply have too many bills to be paid. But if your paycheck isn’t much more than what you’re borrowing, you can see where the trouble starts. You may get stuck, constantly taking out loans to pay back the payday lender.
Borrowing from friends and family.
This can be a great idea for you and your creditor, who gets paid. And as Ross says, “A good friend of family member is likely to offer very favorable conditions when lending money.”
Why this may not be a good short-term fix: It’s not such a great deal for your friend or family member. If you can repay the loan in short order, it may strengthen your bonds. But what if you can’t? You may not lose money in the long run, but you may still pay a high price.
“Entering a financial agreement with a friend or family member can put a significant strain on the relationship,” Ross says.
Overdrawing your account.
This often isn’t done on purpose, but some consumers likely overdraw their bank account knowing that while they’ll be hit with a fee, at least they’ve made the electric company happy by paying their bill. Other consumers may find themselves playing a cat-and-mouse game with their bank account, hoping they won’t be overdrawn but betting on the fact that transactions sometimes take days to post.
Why this isn’t a good short-term fix: This short-term fix often leads consumers to take out loans, defer payments and borrow from friends and family.
According to the CFPB, the median bank overdraft fee is $34. Rack up a few of those every month, and the amount of money you’re forking over starts to look obscene. If you’re really having trouble managing your money, the best fix is to contact your creditor and explain your situation, says Jay Sidhu, CEO of BankMobile, a division of Customers Bank, headquartered in Phoenixville, Pennsylvania.
“Nine times out of 10, they will be empathetic to your issues and grant you the grace period you are looking for with no penalties or cost to you,” Sidhu says. Based on his 20-plus years in banking, he says first-time offenders generally get a break. However, “make sure you don’t make this a habit,” he cautions.
But what if relying on short-term fixes to solve your money problems is becoming a habit? The diagnosis isn’t pretty, and you may need far more than bandages. You may need the equivalent of a doctor or a hospital – a new budget, a new job and a new way of thinking about money.
