What happens when your emergency fund isn’t enough?
Long-term unemployment or a medical emergency can easily dry up a once-healthy rainy day fund, leaving consumers wondering where to turn next. According to a recent consumer expectations survey by the New York Federal Reserve, only one in three Americans say they wouldn’t be able come up with $2,000 within a month to cover an unexpected expense.
It’s during times of vulnerability like this that it’s easy to jump at seemingly quick and easy sources of cash, like payday lenders, credit cards, or even your 401(k).
Unfortunately, practically every potential source of cash that doesn’t come from your own piggy bank is going to cost you in some way.
But at this point, it’s all about choosing the lesser of all evils — when all you have are crummy options, how do you decide which one is the best of the worst?
We’ve ranked common sources of emergency short-term cash from best to worst, which can help you sort through your borrowing options when your savings dry up.
#1 Personal loan from family and friends
It’s an uncomfortable conversation to have with a loved one, but asking a friend or relative for a small loan can be a far better idea than turning to high-interest credit debt, or worse, payday lenders. Unless they’re offering, it doesn’t have to be an interest-free loan. Agree on an interest rate that seems fair and is lower than what you’d find through a bank or other lender.
Because you have a relationship already, you may have an easier time convincing them to lend you money versus a bank that would make the decision after doing a credit check and evaluating other financial information.
#2 (tie) Lender-backed personal loan
A personal loan can be a solid borrowing option if you need money in a pinch or you’re looking to consolidate other debt. The process to apply for a personal loan is similar to applying for a credit card or auto loan, in that the lender will run your credit and offer you a certain rate based on your creditworthiness.
If your credit is poor, that doesn’t necessarily mean you’re out of the running for a personal loan, but it will cost you in the form of much higher interest charges. For example, Lending Club offers loans with APRs from 5.99% to 35.85%, but it’s willing to lend to people with a credit score as low as 600. You can get rates from multiple lenders without impacting your credit score here.
Why choose a personal loan over a credit card? It really comes down to math. If you can find a personal loan that will cost less in the long term than using a credit card, then go for it. Use this personal loan calculator to estimate how much a loan will cost you over time. Then, run the same figures through this credit card payoff calculator.
#2 (tie) Credit cards
If your need for cash is truly short-term and you have enough income to pay it off quickly, then credit card debt can be a decent option. This option gets even better if you can qualify for a card with a 0% interest offer. The card will let you buy some time by allowing you to cover your essentials while you work on paying off the balance.
Because the debt is unsecured, unlike an auto title loan, you aren’t putting your assets at risk if you can’t pay.
#3 Home equity line of credit (HELOC)
You may be able to leverage the equity in your home to cover short-term emergency needs. A HELOC, or home equity line of credit, is a revolving credit line extended to a homeowner using your home as collateral. How much you can take out will depend on your home’s value, your remaining mortgage balance, your household income, and your credit score. A home equity line of credit may allow you to borrow the maximum amount, or only as much as you need. You will also be responsible for the costs of establishing and maintaining the home equity line of credit. You can learn more about these here.
You’ll choose the repayment schedule and can set that for less than 10 years or more than 20 years, but the entire balance must be paid in full by the end of the loan term. You’ll pay interest on what you borrow, but you may be able to deduct it from your income taxes. Keep in mind that if you are unemployed, it will be unlikely that you’ll be approved for a HELOC.
HELOC vs. Personal loans
Because home equity lines of credit are secured against the borrower’s home, if you default on your home equity line of credit, your lender can foreclose on your home. Personal loans, on the other hand, are usually unsecured, so, while failure to make your payments on time will adversely impact your credit, none of your personal property is at risk.
#4 A 401(k) loan
A 401(k) loan may be a good borrowing option if you’re in a financial pinch and are still employed. And it is a far better bet than turning to a payday lender or pawn shop for a loan. Because you’re in effect borrowing from yourself, any interest you pay back to the account is money put back in your retirement fund. You are allowed to borrow up to $50,000 or half of the total amount of money in your account, whichever is less. Typically, 401(k) loans have to be repaid within five years, and you’ll need to make payments at least quarterly.
But there are some cons to consider. If you get laid off or change jobs, a 401(k) loan immediately becomes due, and you’ll have 60 days to repay the full loan amount or put the loan funds into an IRA or other eligible retirement plan. If you don’t make the deadline, the loan becomes taxable income and the IRS will charge you another 10% early withdrawal penalty.
#5 Roth IRA or Roth 401(k) withdrawal
Generally, withdrawing funds from your retirement savings is a big no-no, because you’re going to miss out on any gains you might have enjoyed had you kept your money in the market. On top of that, there are fees and tax penalties, which we’ll cover in the next section.
But there is an exception: the Roth IRA or Roth 401(k).
Because funds contributed to Roth accounts are taxed right away, you won’t face any additional tax or penalties for making a withdrawal early. The caveat is that you can only withdraw from the principal amount you’ve contributed — you’re not allowed to withdraw any of the investment gains your contributions have earned without facing taxes and penalties.
However, it is still true that any money you take out is money that will not have a chance to grow over time, so you will still miss out on those earnings.
#6 Traditional 401(k) or IRA withdrawal
Experts typically recommend against borrowing from your 401(K) or IRA, but when you’re in desperate need of cash, it may be your best option.
Just understand the risks.
If you withdraw funds from a traditional retirement account before age 59 1/2 , the money will be taxed as income, and you’ll be charged a 10% early distribution penalty tax by the IRS. You may want to speak with a tax professional to estimate how much you’ll have to pay in taxes and take out more than you need to compensate for that loss. There’s no exception to the income tax, but there are a number of exceptions to the 10% penalty, such as qualified education expenses or separation from service — when you leave a company, whether by retirement, quitting, or getting fired or laid off — at 55 years or older.
When you take that money out, not only will you lose out on potential tax-deferred investment growth, but you’ll also lose a huge chunk of your retirement savings to taxes and penalties.
#7 Reverse mortgage
Homeowners 62 years old and older have another option for cash in a pinch: a reverse mortgage. With a reverse mortgage, your property’s equity is converted into (usually) tax-free payments for you. You can take the money up front as a line of credit, receive monthly payments for a fixed term or for as long as you live in the home, or choose a mix of the options. You keep the title, but the lender pays you each month to buy your home over time.
In most cases, you won’t be required to repay the loan as long as you’re still living in your home. You’ll also need to stay current on obligations like homeowners insurance, real estate taxes, and basic maintenance. If you don’t take care of those things, the lender may require you to pay back the loan.
The loan becomes due when you pass away or move out, and the home must be sold to repay the loan. If you pass away, and your spouse is still living in the home but didn’t sign the loan agreement, they’ll be allowed to continue living on the property, but won’t receive any more monthly payments. When they pass away or move out, the home will be sold to repay the loan.
The reverse mortgage may take a month or longer to set up, but once you get the paperwork set you can choose to take a line of credit, which could serve as an emergency fund, advises Columbus, Ohio-based certified financial planner Tom Davison.
He says the reverse mortgage’s advantages lie in the fact that it doesn’t need to be paid back until the homeowner permanently leaves the house, and it can be paid down whenever the homeowner is able. You can also borrow more money later if you need it, as the line of credit will grow at the loan’s borrowing rate.
Take care to look at the fine print before you sign. Under current federal law, you’ll only have three days, called a right of rescission, to cancel the loan. Reverse mortgage lenders also usually charge fees for origination, closing, and servicing over the life of the mortgage. Some even charge mortgage insurance premiums. Also, if you pass away before the loan is paid back, your heirs will have to handle it.
#8 Payday loan alternatives
While regulators work to reign in the payday lending industry, a new crop of payday loan alternatives is beginning to crop up.
Services like Activehours or DailyPay allow hourly wage earners to get paid early based on the hours they’ve already worked. Activehours allows you to withdraw up to $100 each day and $500 per pay period, while DailyPay, which caters to delivery workers, has no cap. DailyPay tracks the hours logged by workers and sends a single payment with the day’s earnings, minus a fee ranging from 99 cents to $1.49.
Another alternative could be the Build Card by FS Card. The product targets customers with subprime credit scores and offers an initial low, unsecured $500 credit limit to borrowers, which increases as they prove creditworthiness. The card will cost you a $72 annual membership fee, a one-time account setup fee of $53, plus $6 per month just to keep it in your wallet. It also comes with a steep interest rate — 29.9%. After all of the initial fees, your initial available limit should be about $375.
#9 Pawn shop loans
Pawn shop loan interest charges can get up to 36% in some states and there are other fees you’ll have to pay on top of the original loan.
Pawn shops get a shady rap, but they are a safer bet than payday lenders and auto title loans. Here’s why: Because you are putting up an item as collateral for a payday loan, the worst that can happen is that they take possession of the item if you skip out on payments. That can be devastating, especially if you’ve pawned something of sentimental value. But that’s the end of the ordeal — no debt collectors chasing you (payday loans) and no getting locked out of your car and losing your only mode of transportation (title loans).
#10 Payday loans and auto title loans
We have, of course, saved the worst of the worst options for last.
When you borrow with a payday loan but can’t afford to pay it back within the standard two-week time frame, it can quickly become a debt trap thanks to triple-digit interest rates. According to a recent study by the Pew Charitable Trusts, only 14% of payday loan borrowers can afford enough out of their monthly budgets to repay an average payday loan. Some payday lenders offer installment loans, which require a link to your bank account and gives them access to your funds if you don’t pay.
Some payday lenders today require access to a checking account, meaning they can dip in and take money from your bank account if you miss a payment. Also, your payday loan will be reflected on your credit report. So if things end badly, your credit will suffer as well. They have no collateral, so payday lenders will continue to hound you if you miss payments.
And, of course, auto title lenders require you to put up your wheels as collateral for a loan. And if you rely heavily on your car to get to and from work, having it repossessed by a title lender could hurt you financially in more ways than one.
The loans are usually short-term — less than 30 days — so this might not be a good option for you if you don’t foresee a quick turnaround time for repayment. If your household depends on your car for transportation, you may not want to try this option as there is a chance you could lose your car. If you don’t repay the loan, the lender can take your vehicle and sell it to cover the loan amount.
One more thing to watch out for is the advertised interest rate. Auto title lenders will often advertise the monthly rate, not the annualized one. So a 20% interest rate for the month is actually a 240% APR.