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How to Find the Right 529 Savings Plan for You

Editorial Note: The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

It is never too early to think about saving for college, and a 529 savings plan can help you do just that.

No other savings or investment account offers the tax breaks that a 529 college savings plan offers, which means that every dollar you contribute can cover a greater share of college costs. That’s especially helpful considering the average net price of a private nonprofit university came in at $26,740 for the 2017-18 school year, and the cost of college is on the rise.

But with almost every state offering a 529 savings plan, and with many offering more than one, it can be challenging to figure out which plan is right for you.

If you’re already well-versed in this savings tool, you can see our roundup of the best options here:

The truth is that contributing to a 529 savings plan isn’t always the right move. You may be better off using a different college savings account or even focusing on other financial responsibilities first.

This guide will help you sort through all of that. You’ll learn what a 529 college savings plan is, how it works, how to choose the right plan for you and alternatives you should consider.

What is a 529 college savings plan and how does it work?

A 529 college savings plan is an investment account that offers a number of tax breaks when the money is used for qualified education expenses:

  • Contributions are made after taxes, though there are a number of states that allow either a deduction or a credit for state income tax purposes.
  • Your money grows tax-free while it is in the account.
  • Money can be withdrawn tax-free for qualified education expenses, which typically includes tuition at any eligible school from elementary onward, as well as fees, books and room and board at an eligible higher education institution. If you withdraw the money for any other type of expense, the earnings will be taxed and subject to a 10% penalty.

529 savings plans offer a preselected set of mutual funds and your account balance will rise and fall based on your contributions and the performance of your chosen investments. Most 529 savings plans also offer age-based investments that provide an all-in-one portfolio and automatically become more conservative as your child approaches college.

529 savings plans are administered by states, with every state except for Wyoming offering at least one plan. However, you do not have to use your home state’s plan, and in some cases, you may be better off going elsewhere.

Regardless of which 529 savings plan you choose, you can withdraw the money tax-free for expenses incurred at any eligible school in any state, and even for certain international schools.

Anyone can open a 529 savings plan and name anyone else, including himself, as the beneficiary. You can also change the beneficiary later on, as long as the new beneficiary is related to the old beneficiary.

In short, 529 savings plans allow you to save and invest for future education expenses in a tax-advantaged way.

Prepaid tuition plans vs. savings plans

In addition to 529 savings plans, some states also offer prepaid tuition plans that may be advantageous in certain situations.

Prepaid tuition plans allow you to buy units that each typically cover 1% of one year’s worth of college tuition at a public, in-state university. This essentially allows you to lock in the current cost of college, protecting you against the risk that tuition costs will continue to rise.

“The huge part of a prepaid tuition plan is that it’s guaranteed,” said Angie Furubotten-LaRosee, fee-only CFP and founder of Avea Financial Planning. “With a traditional 529 plan you have to worry about market fluctuations, and with these you don’t.”

There are downsides, though. The biggest of which is that while you can usually get your money back if your child wants to go to a private college or go out of state, the return is typically much smaller than what you would get from attending an in-state public school.

This is in contrast to a 529 savings plan, which allows you to use the money you’ve earned at any eligible institution.

“Prepaid plans are ideal for parents who have a good idea of where their child will attend college and who are willing to give up investment flexibility to lock in those costs,” said Kathleen Boyd, CFP and wealth adviser at Navigoe. “However, if you’re uncertain about your child’s future college plans, then a 529 savings plan may be the ideal option.”

Benefits of a 529 savings plan

1. Tax breaks

The tax breaks are the main advantage of 529 savings plans over other savings and investments accounts.

The growth and the ability to withdraw the money all tax-free for qualified education expenses mean that every dollar you contribute can multiply faster and cover a greater portion of your education expenses.

And if you live in one of the states that offers a state income tax break for contributions, you can potentially afford to make a bigger contribution without affecting your monthly budget, allowing you to get an even bigger head start.

“If you are in a state that offers good benefits, and some states even offer matching funds, it really is the right choice at that point because you aren’t going to get those benefits from any other option,” said Nannette Kamien, CFP and principal of Inspiration Financial Planning, a fee-only financial planning firm with expertise in helping families prepare for college financially.

2. High contribution limits

If you’d like to save a lot of money for education, a 529 savings plan will allow you to do it.

There is no annual contribution limit, though contributions are subject to gift tax rules, which means that you can effectively contribute $15,000 per year, per child, without exceeding the 2018 gift tax exemption. That limit is applied per donor, meaning that parents can combine their limits to contribute up to $30,000 per year, per child.

The tax code also allows you spread excess contributions over a 5-year period, meaning that as a couple, you could potentially contribute up to $150,000 in a single year without any gift tax consequences.

Most 529 savings plans do have lifetime contribution limits, but those limits are very high. For example, New York allows you to contribute up to $520,000 to any single beneficiary, and Utah allows up to $446,000 per beneficiary.

Additionally, there are no income restrictions on contributions, so anyone can take advantage of a 529 savings plan no matter how much money you make.

3. Mindset and accountability

One of the biggest benefits of contributing to a 529 plan is that it establishes saving for college as a real goal with progress that can be tracked along the way.

“Just having the 529 plan in and of itself solidifies that it’s an important priority for you and your family,” said Furubotten-LaRosee. “It’s now a budget item, it’s identified as money that’s earmarked for college, and I think that setting that habit is half the battle for a lot of people.”

4. Potential for long-term returns

By offering mutual funds that are invested in the stock and bond markets, 529 savings plans allow you to participate in the long-term, compounding returns that those investments offer. This can be especially powerful if you start when your child is young.

“Families who can invest over the long term are prime candidates for 529s,” said Boyd. “The earlier you start, the more time you have to take advantage of compound returns the markets provide over time.”

5. Low impact on financial aid

Many people are hesitant to save for college because of the potential impact on financial aid, but 529 savings plans have a relatively low impact.

As long as the account is held in a parent’s name, only up to 5.64% of the money in a 529 savings plan will be counted on the FAFSA. For example, if you have $100,000 in your 529 savings plan, only $5,640 will be considered for financial aid purposes.

In other words, there’s very little penalty for having money in a 529 savings plan. And the benefits of saving the money ahead of time will almost always outweigh any small decrease in financial aid.

6. Ability to change beneficiaries

529 savings plans allow a reasonable amount of flexibility when it comes to changing the beneficiary of the funds.

You are allowed to change the beneficiary as often as you like, and the only restriction is that the new beneficiary must be a family member of the old beneficiary. For the purposes of 529 plans, “family members” include siblings and stepsiblings, children, stepchildren, and grandchildren, parents, grandparents, nieces, nephews, first cousins and even in-laws.

All of which means that if the money isn’t needed for the original beneficiary, you can simply use it for another family member.

Pitfalls of 529 savings plans

1. Taxes and penalties if not used for education

The biggest downside to using a 529 savings plan is that if you withdraw money for anything other than qualified education expenses, the earnings will be subject to taxes and a 10% penalty.

This is one reason to be careful about over-contributing, and also to not contribute money that may be needed for other financial goals.

“That’s where that overarching financial plan comes into play,” said Furubotten-LaRosee. “You can always use other vehicles, like a Roth IRA, that come with more flexibility.”

2. Investment options can be narrow and confusing

Each 529 plan offers its own preselected set of investment options, and those options vary widely in terms of what they invest in and how much they cost. Sorting through all of those options and making the best choices for your needs can be difficult.

“Sometimes I see that parents are afraid to really invest the money and they don’t understand what the different investment options mean,” said Kamien. “Sometimes they get stuck in investments that are higher cost, and that really eats into the earnings that they could have gotten.”

Kamien said that she encourages people to look for “age-based index” options. These funds provide an all-in-one portfolio that automatically gets more conservative as your child approaches college, and they build the portfolio with index funds, which are generally low cost and have been shown to outperform actively managed funds the majority of the time.

3. Other financial responsibilities may be more important

While saving for college is a great goal, it’s often a good idea to handle other financial responsibilities first. This is especially important to consider before contributing money to a 529 savings plan because of the taxes and penalties on nonqualified withdrawals.

“I certainly would caution a parent or grandparent against sacrificing their own financial goals like saving for an emergency fund, paying off debt or retirement plans to contribute to a 529 plan,” said Boyd. “Saving for education is very important, but it’s also a luxury and a privilege for your children, and it shouldn’t come above your own financial security.”

How to compare 529 savings plans

When it comes to choosing a 529 savings plan, start by looking at the potential tax breaks offered by your home state’s plan, said Fred Amrein, a college funding expert and the founder of EFC Plus.

“You need to understand your in-state plan first, and if the beneficiary is in another state you need to understand their state’s plan next,” Amrein said. “In some cases, it may be more beneficial to gift the money to the beneficiary or the beneficiary’s parents and let them contribute the money.”

Even if your state does offer tax breaks, it’s not a given that your home state’s plan is the best option. There are a few more major variables you should consider as you compare 529 savings plans.

Here are the criteria we used to construct our list of best 529 plans.

Out of state

We evaluated each 529 savings plan from the perspective of an out-of-state resident. That means that state income tax breaks were not considered and that any 529 plans that are unavailable to out-of-state residents were ruled out.

Fees

Research has shown that cost is the best predictor of future investment performance, with lower costs leading to better returns. For that reason, we preferred 529 plans that minimized both investment and administrative fees.

We also filtered out adviser-selling 529 plans, which are specifically designed to be sold and managed by financial advisers and have higher fees in the form of commissions and management fees. Given that financial advisers can also advise on 529 plans that are sold directly to the consumer, and therefore cost less, we limited our search to those direct-sold plans.

Investment options

Investment portfolios built with index funds have been shown to outperform actively managed portfolios 80%-90% of the time, and we therefore only included 529 savings plans that offer index funds.

We also limited our list to 529 savings plans that offer age-based portfolios constructed with index funds, since these all-in-one portfolios simplify the investment process and automatically decrease your investment risk as your child nears college age.

Finally, we preferred 529 savings plans that offered access to individual index funds that allow investors to build custom portfolios if they so choose.

Minimum investment

Finding room in your budget for college savings can be difficult, so we did not consider any 529 savings plan that required a significant minimum investment.

None of the plans listed below require more than a $50 initial investment.

Other features

While most 529 savings plans offer most of the same basic features, we did consider additional features offered by certain plans that may be helpful for some investors.

The nine best 529 savings plans

Fidelity Arizona College Savings Plan

Arizona’s College Savings
Arizona’s College Savings Plan is managed by Fidelity, just like Delaware, Massachusetts and New Hampshire, which also appear on this list. Each of these states offers essentially the same plan.The index funds are high quality and low cost, and there are no other significant fees, though the presence of higher-cost actively managed funds could lead some people to pay more than they have to.

  • Investment options: Age-based portfolios constructed with Fidelity index funds, as well as access to individual Fidelity index funds if you’d like to customize your portfolio.
  • Fees: Age-based index funds range from 0.13%-0.16% per year. Individual index funds range from 0.13%-0.18% per year. There are no account maintenance fees.
  • Minimum initial investment: $15 with enrollment in automatic contributions. $50 otherwise.
  • Other features: None of note.
  • Website: https://www.fidelity.com/go/529-arizona/overview

California ScholarShare 529

ScholarShare 529
Managed by TIAA-CREF, California offers a selection of both index funds and actively managed funds. The lineup of passive age-based funds and individual index funds is strong.
  • Investment options: Age-based portfolios constructed with TIAA-CREF index funds, as well as access to individual TIAA-CREF index funds, if you’d like to customize your portfolio.
  • Fees: Age-based index funds range from 0.11%-0.17% per year. Individual index funds range from 0.08%-0.20% per year. There are no account maintenance fees.
  • Minimum initial investment: $15 with enrollment in automatic contributions. $25 otherwise.
  • Other features: None of note.
  • Website: https://www.scholarshare529.com

Delaware College Investment Plan

Delaware College Investment Plan

Delaware’s College Investment Plan is managed by Fidelity, just like Arizona, Massachusetts and New Hampshire. These states offer essentially the same plan.

The index funds are high-quality and low-cost and there are no other significant fees. The plan does offer higher cost actively managed funds, which could lead some people to pay more than they have to.

  • Investment options: Age-based portfolios constructed with Fidelity index funds, as well as access to individual Fidelity index funds if you’d like to customize your portfolio.
  • Fees: Age-based index funds range from 0.13%-0.16% per year. Individual index funds range from 0.13%-0.18% per year. There are no account maintenance fees.
  • Minimum initial investment: $15 with enrollment in automatic contributions. $50 otherwise.
  • Other features: None of note.
  • Website: https://www.fidelity.com/go/529-delaware/overview

Illinois Bright Start Direct-Sold College Savings Program

Illinois Bright Start Direct-Sold College Savings Program
The index age-based funds use Vanguard mutual funds with some of the lowest fees offered by any 529 savings plan. Even the higher-cost “multi-firm” age-based funds cost less than most actively managed funds offered by other plans.

  • Investment options: Age-based portfolios constructed with Vanguard index funds, as well as access to individual Vanguard index funds and DFA funds — a highly respected group of mutual funds that are typically only available through financial advisers — if you’d like to customize your portfolio.
  • Fees: Age-based index funds range from 0.12%-0.15% per year. Individual Vanguard index funds range from 0.10%-0.18% per year. There are no account maintenance fees.
  • Minimum initial investment: None
  • Other features: None of note.
  • Website: https://www.brightstartsavings.com

College Savings Iowa

College Savings Iowa
Every investment offered within Iowa’s 529 savings plan is managed by Vanguard and costs just 0.20% per year. And with a strong lineup of both age-based portfolios and individual mutual funds, you have plenty of room to personalize your investment plan.

  • Investment options: Age-based portfolios constructed with Vanguard index funds, as well as access to individual Vanguard index funds if you’d like to customize your portfolio.
  • Fees: Every investment option costs 0.20% per year. There are no account maintenance fees.
  • Minimum initial investment: $15 with enrollment in automatic contributions. $25 otherwise.
  • Other features: None of note.
  • Website: https://www.collegesavingsiowa.com

Massachusetts U.Fund College Investing Plan

Massachusetts U.Fund College Investing Plan
Massachusetts U.Fund College Investing Plan is managed by Fidelity. The plan is essentially the same as Arizona’s, Delaware’s and New Hampshire’s.

It offers high-quality, low-cost index funds with no other significant fees, though the presence of higher cost actively-managed funds could lead some people to pay more than they have to.

  • Investment options: Age-based portfolios constructed with Fidelity index funds, as well as access to individual Fidelity index funds if you’d like to customize your portfolio.
  • Fees: Age-based index funds range from 0.13%-0.16% per year. Individual index funds range from 0.13%-0.18% per year. There are no account maintenance fees.
  • Minimum initial investment: $15 with enrollment in automatic contributions. $50 otherwise.
  • Other features: None of note.
  • Website: https://www.fidelity.com/529-plans/massachusetts

New Hampshire UNIQUE College Investing Plan

New Hampshire UNIQUE College Investing Plan
New Hampshire’s UNIQUE College Investing Plan is managed by Fidelity, just like Arizona, Delaware and Massachusetts. Each of these states’ plans are on this list and are basically the same.

New Hampshire’s plan offers high-quality, low-cost index funds with no other significant fees. However, the plan offers higher cost actively-managed funds, which could lead some people to pay more than they have to.

  • Investment options: Age-based portfolios constructed with Fidelity index funds, as well as access to individual Fidelity index funds if you’d like to customize your portfolio.
  • Fees: Age-based index funds range from 0.13%-0.16% per year. Individual index funds range from 0.13%-0.18% per year. There are no account maintenance fees.
  • Minimum initial investment: $15 with enrollment in automatic contributions. $50 otherwise.
  • Other features: None of note.
  • Website: https://www.fidelity.com/529-plans/new-hampshire

New York’s 529 College Savings Program

New York’s 529 College Savings Program
Like Iowa, New York’s 529 College Savings Program offers only Vanguard index funds and index age-based funds, and in this case, the cost of each fund is even lower at 0.15% per year.

If your priority is minimizing fees and accessing Vanguard funds, this is likely the plan for you.

  • Investment options: Age-based portfolios constructed with Vanguard index funds, as well as access to individual Vanguard index funds if you’d like to customize your portfolio.
  • Fees: Every investment option costs 0.15% per year. There are no account maintenance fees.
  • Minimum initial investment: $0.
  • Other features: None of note.
  • Website: https://www.nysaves.org

Utah my529

Utah my529

Utah’s my529 offers possibly the most noteworthy set of features of any 529 savings plan:

  1. You can create your own age-based portfolio from the underlying funds offered by the plan, which include Vanguard index funds as well as DFA funds that are typically only offered by financial advisers.
  2. If you are working with a financial adviser, you can give him or her access to your 529 plan in order to manage your investments.

The fees are slightly higher than the other 529 savings plans listed here — though they are still very low — but the investment capabilities are second to none.

  • Investment options: A wide variety of age-based portfolios, Vanguard index funds and DFA funds.
  • Fees: Age-based index funds range from 0.169%-0.202% per year. Vanguard individual index funds range from 0.22%-0.40% per year and DFA funds range from 0.37%-0.72% per year. There are no account maintenance fees.
  • Minimum initial investment: $0.
  • Other features: Customized age-based portfolios and financial adviser access.
  • Website: https://my529.org

How to enroll in a 529 savings plan

Once you know which 529 savings plan you want to use, it’s time to open an account and make your first contribution. And while every plan will have a slightly different process, there are a few steps that are likely to be similar across the board:

  1. Have the necessary information ready for the account owner:
    1. Social Security number
    2. Birth date
    3. Mailing address
    4. Physical address
    5. Bank account number and routing number for making contributions
  2. Have the necessary information ready for the beneficiary
    1. Social Security number
    2. Birth date
    3. Mailing address
    4. Physical address
  3. Read the program description, which can be found on the 529 plan’s website
  4. Choose an investment strategy. You can review the options on the 529 plan’s website and in the program description.
  5. Start the application process online or submit the appropriate paperwork.

How to use 529 plans to pay for K-12 private education

The recently passed Tax Cuts and Jobs Act expanded the flexibility of 529 savings plans by allowing investors to withdraw up to $10,000 per year, per child tax-free and penalty-free for tuition for elementary or secondary school.

This opens up more opportunities for parents to use 529 funds for their child’s education. But given how new the law is, it’s a good idea to proceed carefully.

According to Amrein, the tax implications of withdrawing 529 money for K-12 tuition are straightforward on the federal side but are yet to be determined on the state side.

“What a lot of states are dealing with is a lot of them had incentive programs for college contributions,” said Amrein. “What I’m hearing is some of the states are either going to withdraw that incentive or, if you use it for K-12 expenses, there may be a clawback provision that they can rescind that tax break you received for previous contributions.”

If you live in a state that offers tax breaks for 529 plan contributions, and if you’ve taken advantage of those tax breaks, you may want to speak to an accountant before using your 529 funds for K-12 tuition.

Alternatives to 529 savings plans

While the tax breaks offered by a 529 savings plan are hard to beat if you’re saving money specifically for education, there are a number of other savings and investment accounts that can be more advantageous, depending on the specifics of your situation.

Here are some of the major alternatives to consider.

Roth IRA

While Roth IRAs are technically retirement accounts, they have a few characteristics that make them attractive college savings accounts:

  • They offer tax-deferred growth while the money is inside the account.
  • You can withdraw up to the amount you’ve contributed at any time and for any reason without tax or penalty.
  • Early withdrawals of Roth IRA earnings used for higher education are taxed but are not subject to the typical 10% penalty.
  • If you don’t need the money for college, you can keep it in the Roth IRA and use it tax-free for retirement.

“I’m a big proponent of incorporating a Roth into college planning, especially when you have a teenager who is hopefully earning money,” said Furubotten-LaRosee. “Starting the savings habit is a biggie, and if you don’t use it for college it’s available for retirement or any other goal.”

The big downsides are that Roth IRAs are not as tax-efficient as 529 savings plans when used for college and that by dedicating your Roth IRA for college savings, you’re using up valuable retirement space.

Still, the flexibility is often worth it.

Taxable investment account

A regular, taxable investment account doesn’t offer any tax advantages, but it does provide maximum flexibility to invest in whatever you’d like and to use the money at any time and for any reason.

“As a parent, sometimes you need flexibility with your money,” said Furubotten-LaRosee. “You need the ability to control things as life progresses, and not having it tied into a 529 plan means you can access it when you need to.”

Coverdell ESA

The primary benefit of a Coverdell Education Savings Account (ESA) used to be the ability to allocate the money for K-12 expenses, but that benefit is much less relevant now that 529 savings plans can also be used for the same purpose.

Coverdell ESAs also come with stricter contribution limits than 529 savings plans. Contributions are limited to $2,000 per year, per child across all contributors. Once your Modified AGI (adjusted gross income with certain deductions like student loan interest added back) exceeds $110,000 for individuals or $220,000 for married couples filing jointly, you can no longer contribute.

According to Amrein, the main benefit of a Coverdell ESA at this point is the ability to choose from a much wider range of investment options than you can get from a 529 plan.

“It’s kind of like comparing a 401(k) to an IRA,” said Amrein. “Most 529 plans are very restrictive, with maybe five to 10 investment options to choose from. On the Coverdell side, you can invest in anything you want, but you’re limited to $2,000 per year.”

Savings account

While a savings account can’t offer the long-term returns that you might get from a 529 savings plan, Roth IRA or Coverdell ESA, it is a simple and safe choice that can make sense either as a starting point or if your child will be starting college soon.

And Furubotten-LaRosee argues that no matter which account you choose, the main priority should simply be to separate your college savings from your regular checking and savings accounts.

“Even if it’s just in a separate savings account, the main thing is having it really separate and earmarked for college,” said Furubotten-LaRosee. “That gives it a little protection from your day-to-day spending.”

Choosing the right 529 savings plan for you

529 savings plans allow you to save a lot of money while being tax-efficient for your child’s education, which can help defray the rising costs of college.

The first step is always understanding your home state’s plan to see what kind of tax breaks are available. Then, you can compare it with other states to determine which 529 savings plan will allow you to minimize costs and access the best investment options.

Finally, you can make your decision within the context of your entire financial plan. Saving for college is a fantastic goal, and 529 savings plans are a powerful way to do it, but it shouldn’t come at the expense of other financial responsibilities.

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Matt Becker
Matt Becker |

Matt Becker is a writer at MagnifyMoney. You can email Matt here

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Mortgage

How to Use Your Mortgage Cash-Out Refinance

Editorial Note: The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

203k loan

If you need money to pay for a big expense — such as college tuition, making home improvements or paying off credit card debt — and if you don’t have the savings to handle it, a cash-out refinance could help.

A cash-out refinance allows you to borrow from the equity you’ve built in your home, often at lower interest rate than other loans, and receive cash that can be used for just about any purpose. It can be a relatively cheap way to borrow money for important expenses.

But there are some risks involved with cash-out refinancing, and in certain situations, the cost will be higher than the alternatives.

This article explains what cash-out refinancing is, and dives into the pros and cons so that you can make the right decision for your needs.

What is cash-out refinancing?

A cash-out refinance involves taking out a new loan that is larger than your existing mortgage so that you can replace your old mortgage and walk away with extra cash that you can use for other financial goals.

For example, if you currently have a $150,000 mortgage on a home that’s worth $250,000, you could potentially refinance into a $180,000 loan that replaces your old mortgage and provides $30,000 that can be used for any purpose.

This is different than a traditional rate and term refinance in which your new loan balance is the same as your old loan balance.

With a traditional refinance, the primary goal is usually to reduce your interest rate and/or reduce your loan term in order to save money and potentially pay off your mortgage sooner.

With a cash-out refinance, the goal is generally both to improve the terms of your existing mortgage and tap into your home equity to help fund other financial goals.

Michael Dinich CRPS, a financial planner and the founder of Your Money Geek, says that a cash-out refinance can be an attractive way to pay for things like home improvements — in which case the interest would likely be tax deductible since the loan would be used to substantially improve the homes — or even pay off higher-interest debt like credit cards. The interest rate on cash-out refinances is usually lower than other forms of debt, such as personal loans or credit cards, because you are using collateral to back the loan (your home).

But there are some things to watch out for as well.

First, a cash-out refinance turns an asset — your home equity — into debt, which is always a decision that should be made carefully.

Second, the cash proceeds are typically first used to pay closing costs and other upfront expenses like property taxes and homeowners insurance, so you won’t always receive the full difference between your new loan amount and your old loan amount. You can apply for a no-cost refinance, but that just means that you’ll receive a higher interest rate or the closing costs will be added to the loan, so there’s really no escaping the cost.

Third, a larger loan could increase your monthly payment, and even if it doesn’t, you may end up paying more interest over the life of your loan if you are extending your loan term.

LendingTree, the parent company of MagnifyMoney, has a slew of tools to help you do the math. You can use this cash-out refinance calculator to estimate your monthly payment and this loan payment calculator to estimate your total interest cost.

So how do you decide whether a cash-out refinance is the right move for you? Let’s first look at how you can qualify and then look at situations in which it may or may not make sense.

How do you qualify for a cash-out refinance?

There are a few criteria you’ll have to meet in order to be eligible for a cash-out refinance.

Credit score

You must have a credit score of at least 620 in order to qualify for a cash-out refinance on your primary home. There are several ways to check your credit score for free, and you can use these six steps to improve your score if it isn’t yet where it needs to be.

Loan-to-value ratio

The maximum allowable loan-to-value ratio for a cash-out refinance is 80%, meaning that your total outstanding home loan balance after the refinance is complete can’t exceed 80% of the value of your home.

As an example, if your home is currently valued at $250,000, your new loan — combined with all other house related debt such as a home equity loan or HELOC — can’t exceed $200,000. If your outstanding debt is already greater than $200,000, you won’t be eligible for a cash-out refinance.

If you are looking to refinance a second home or an investment property, the maximum allowable loan-to-value ratio is lowered to 75%.

If you have a VA loan, you may be able to secure a cash-out refinance even if you don’t meet those loan-to-value requirements, but your maximum loan amount is capped depending on where you live and the type of property you are refinancing.

Debt-to-income ratio

Your debt-to-income ratio is the sum of all your monthly debt payments — including student loans, credit cards, and auto loans, in addition to your mortgage payments — divided by your gross monthly income. It must be 50% or less in order to qualify for a cash-out refinance.

Financial documentation

You will have to provide documentation that verifies your income and assets and proves that you are able to afford the loan. This documentation will vary by lender but often includes at least the following:

  • Your two most recent tax returns
  • Your two most recent W-2s
  • Bank statements for the past two months
  • Investment statements for the past quarter
  • Pay stubs from the most recent month

How those factors affect the cost of a cash-out refinance

While meeting the minimum requirements should allow you to qualify for a cash-out refinance, you can save money by improving these variables.

Specifically, lenders may collect a surcharge that varies based on your credit score and loan-to-value ratio.

If your credit score is 680 or above and your loan-to-value ratio is 60% or less, you can avoid the surcharge. But if your credit score dips below that threshold or your loan-to-value rises above it, your fee will range from 0.25%-3% the value of your loan.

For example, let’s say that your home is worth $250,000, your current mortgage balance is $150,000, and you’d like a cash-out refinance for $200,000 — an 80% loan-to-value ratio — so that you have $50,000 available for other goals.

If your credit score is between 700 and 739, you’ll face a 0.750% surcharge that equates to $1,500.

But if your credit score is just a little bit lower at 680-699, you’ll face a 1.375% surcharge that equates to $2,750. That’s an extra $1,250 for potentially just a few points difference in credit score.

All of which is to say that getting yourself in peak financial condition will help you qualify for a cash-out refinance and make it less costly.

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Good ways to use your cash-out refinancing

There are many different ways you can use your cash-out refinance, some of which could help you improve your financial situation, save you money and even increase the value of your home.

Here are a few good ways to use your cash-out refinance.

Home improvements

Certain home improvements, such as replacing your entry door or upgrading your kitchen, can increase the value of your home in addition to making it a more enjoyable living space. And if you don’t have the savings to pay for it outright, using a cash-out refinance to fund those improvements can be a smart move.

“It may make sense to tap home equity for home improvements because the interest rate is lower than other forms of borrowing”, said Dinich.

Another benefit of using a cash-out refinance to improve your home is that the interest should be deductible. Under the Tax Cuts and Jobs Act, only interest on home loans used to buy, build or substantially improve your deductible, and home improvements should fit the definition.

It’s worth noting though that not all home improvements will increase the value of your home. Pools often don’t represent a good return on investment, and you also need to be careful about upgrading your home too far above the rest of your neighborhood.

This is one area where it pays to do your research. A good decision can pay off, but an uninformed decision may cost you money.

Paying off high-interest debt

Because the loan is secured by your home, and because it’s considered a first mortgage, a cash-out refinance typically has lower interest rates than other forms of debt.

This not only makes cash-out refinancing an attractive option compared with other loans, but it can make it a good way to pay off other loans and save some money in the long-term.

If you have credit card debt or private student loan debt with high interest rates, for example, you may be able to reduce your rate by executing a cash-out refinance, pay off those other loans and reduce your interest charges going forward.

Proceed carefully when it comes to federal student loans though. Those loans have a number of protections — such as income-driven repayment, forgiveness and deferment and forbearance — that would be lost by refinancing. Those protections are often worth more than a lower interest rate.

It’s also worth noting that the interest charged on the portion of the new loan used to pay off debt would not be deductible since that part of the loan wouldn’t be used to buy, build or substantially improve your home.

Paying for college

With college costs on the rise, parents are forced to get creative when the tuition bills come due.

A cash-out refinance may offer a lower interest rate than other types of loans, including parent PLUS federal student loans that are currently issued with a 7% interest rate.

The big downside is that you are using your house as collateral and that you will still be responsible for the loan even if your child drops out or otherwise doesn’t finish his or her education. You are also adding to your personal debt load at a time when you may need to be ramping up retirement savings.

In many cases it will make more sense for your child to take out federal student loans. They offer more protections, and he or she will have decades to pay it off.

Still, this can be an effective strategy in the right situations.

Purchasing an investment property

Using your cash-out refinance to purchase a rental property could serve as an effective long-term investment. The cash flow produced by the rental income could both offset the costs of the refinance and serve as a helpful source of income, and purchasing the property with the proceeds from a cash-out refinance may be cheaper than other forms of borrowing.

“It’s generally less expensive for homeowners to borrow against their primary residence than to borrow for an investment property,” said Dan Green, the founder of Growella and branch manager for Waterstone Mortgage in Cincinnati. “A cash-out refinance on the primary residence can reduce the total interest costs against both properties.”

Risks associated with a cash-out refinance

While a cash-out refinance can be a smart move in the right circumstances, there are some risks as well and in some situations there could be severe financial consequences.

Here are some of the riskier ways to use a cash-out refinance.

Debt consolidation

While using a cash-out refinance to pay off high interest can look like a no-brainer on the surface, there are some significant risks to be aware of.

“Accessing home equity to pay off high-interest credit card debt can be a good strategy, but only when it is in conjunction with the creation of a sustainable spending plan”, said Justin Harvey, a fee-only financial planner and the founder of Quantifi Planning, LLC in Philadelphia.

That is, taking out new debt to pay off old debt is generally only effective if you have a strong budget in place and a sustainable plan to both repay and stay out of debt. If replacing your credit card debt simply frees up space to reload those same credit cards, you could be doing more harm than good.

“Some of the consumers who were most harmed by the 2008 economic collapse were homeowners who treated their primary residence like an ATM during the housing price run-up,’ said Harvey. “When the price correction followed, many were stuck with a high-dollar mortgage on a low-value asset, and some homeowners were even underwater.”

Investing in the stock market

Taking out a loan to invest in the stock market is rarely a good idea. Stock market returns are not guaranteed, especially in the short term, and it’s possible to lose a lot of money in a short period of time.

If your investments do lose value, you may not have the money needed to make your mortgage payments, in which case you could be at risk of foreclosure.

Buying a car

“Taking out money to buy a car might not be a good way to use your equity,” said Jeremy Schachter, branch manager at Pinnacle Capital Mortgage in Phoenix. “You take out that equity and roll the interest over a 30-year period or take maybe a higher interest rate auto loan at a shorter term.”

Interest rates on auto loans are often low, especially if you are buying a new car and/or have excellent credit. And the loan term is typically one to eight years, which is shorter than most home loans and therefore often leads to lower interest costs over the life of the loan even if your interest rate is higher.

Starting a business

Only about half of all new businesses survive five years or longer, and only a third make it to 10 years or more. That’s less than the length of a typical mortgage, which means that you could run into trouble making your loan payments and put your house at risk in the process.

“Not all business loans are secured loans and all mortgage loans are,” said Green. “When your business succeeds, the distinction is less relevant. But when your business fails, having an unsecured loan is an advantage.”

If you do need a loan for your business, here are some alternatives to consider: 17 Options for Small Business Loans.

Lending money to friends and family

Lending money to friends and family is always risky because if the deal goes south, your personal relationship could be in jeopardy.

Financing that loan by taking on new debt yourself adds to the cost and risk of the transaction. And by tying that debt to your house through a cash-out refinance, you’re putting yourself in a position where if your friend or family member can’t pay you back, you could end up losing your home.

Put simply, this is rarely a good idea. If you’re determined to do it though, Green says that you should approach it like you would any other business decision.

“If you’re lending to friends or family members,” Green said, “you should use the same due diligence as with any investment and charge an appropriate interest rate for the risk.”

Should you use a cash-out refinance?

A cash-out refinance often has a lower interest rate than other types of loans because it’s secured by your home and because it’s considered a first mortgage. That can make it an attractive way to pay for big expenses, especially if you can reduce the interest rate on your existing mortgage in the process.

But that debt comes at a cost and it’s always worth evaluating all of your options, from saving the money you need yourself to exploring other types of loans.

In the end, a cash-out refinance is just one tool of many. When it’s used thoughtfully, it can provide a good return on investment. When it’s not, it can be just another costly debt.

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Mortgage

Can I Refinance a Mortgage When My Home Is for Sale?

Editorial Note: The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

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If you’re having trouble paying your bills, or if you’d simply like to reduce your monthly expenses, refinancing your mortgage could be a good option. By reducing your interest rate, extending your loan term, or both, you could stand to significantly reduce your monthly payment.

But refinancing isn’t easy if you’re also in the process of selling your home. Many mortgage lenders may be hesitant to work with you, and there are some rules you’ll have to follow before you can even consider it.

This article explains why you might want to refinance your mortgage while your home is for sale, why lenders might be hesitant to allow it, and how you can maximize your odds of success.

Why You Might Consider Refinancing When Selling Your Home — and Why You Should Think Twice

There are a few situations in which refinancing a home you are trying to sell might seem like a good idea. But there are also some downsides to this approach, and in some situations, those downsides will outweigh any potential benefit.

Here are some of the reasons to consider it, as well as some reasons to think twice.

1. Relieve the burden of two mortgage payments

If you have already moved into a new home and you are now dealing with two mortgage payments, refinancing your older mortgage could be a way to reduce your monthly expenses and make this temporary situation a little more manageable.

One issue with this approach is that the upfront closing costs could outweigh the savings you receive on the monthly payment. This is especially likely if you end up selling your home quickly, as there may not be enough time for you to recoup those upfront expenses.

Dan Green, the founder of Growella and the branch manager for Waterstone Mortgage in Pewaukee, Wis., also warns that refinancing is not a cure-all if you’ve gotten yourself into a difficult financial situation. While it may offer temporary relief, the long-term issue of having to afford two mortgages will remain and you might end up spending a lot of money on something that still leaves you in a tough spot.

2. You can do a no-cost refinance

If you plan on selling your home within the next few months, the typical upfront closing costs associated with refinancing are a big obstacle.

But you may be offered a no-cost refinance in which you’re able to refinance your mortgage without closing costs. And that could be helpful in the right circumstances, as long as you understand the pros and cons.

The term “no-cost” is slightly deceptive because the lender isn’t actually giving you a free pass. They are simply rolling the closing costs into the loan, which increases the amount you’re borrowing and therefore increases the long-term cost of the loan.

The upside is that without the upfront costs, you can start saving money immediately as long as you’re able to lower your monthly payment. If you sell your home relatively quickly, you could end up spending less than if you had kept your original mortgage.

The downside is that since you’re taking out a larger mortgage, you’ll have to pay more the longer you hold it. If you have trouble selling the house or if your plans change and you decide to keep it, you could end up spending more than you would have either with your original mortgage or with a traditional refinance.

3. You’re not planning to sell the home anymore

If your house has been on the market for some time without any success, you might be having some doubts. That may be especially true if you’re in a buyer’s market, leaving you with little leverage for getting the price that you want.

In that case, you might simply decide that you no longer want to sell the house. You may even decide to turn the home into an investment property instead and rent it out to tenants.

According to Green, this is the most suitable reason to refinance while your home is for sale. If your plans have changed, a refinance might be the best way to save money over the long term.

Why lenders are wary of refinancing a home that’s for sale

Even if you decide that refinancing is the right move, you may have trouble finding a lender that’s willing to do it.

Lenders always take on risk when originating a mortgage loan, and some of these risks are even bigger when they’re considering short-term financing.

Default risk

Default risk is the risk that you might not be able to pay the loan back, in which case the lender stands to lose money.

On the one hand, if you are refinancing a mortgage on a home that you are trying to sell, it should theoretically be a short-term loan and that may decrease the odds of default.

If, as Green mentions, you are refinancing in an attempt to relieve some of the stress of a difficult financial situation, you might quickly find yourself in even more financial trouble if you aren’t able to sell your home quickly. And that type of situation could make it harder for you to pay back the loan, which increases the lender’s risk of losing money to default.

Early-repayment risk

According to Casey Fleming, mortgage adviser and author of “The Loan Guide”, lenders make most of their profit when they sell their loans to investors. So in a situation where you’re trying to take out a loan on a property that you’re trying to sell, the lender faces the risk that you’ll pay the loan off early and eliminate their ability to sell it for a profit.

“A lender doesn’t want to book a loan that’s going to be paid off after only a month or two,” said Fleming. “The lender stands to lose quite a bit of money if someone takes out a loan and then sells the property.”

Even if the lender does manage to sell the loan to an investor, part of the sale includes representation and warranties that could cause problems in the case of early repayment.

Fleming said, “The lender represents to the investor that the information in the file is true and correct and affirms that the loan will pay off as planned.”

So if you sell the home and repay the loan within just a few months, the lender may be forced to buy the loan back from the investor, resulting in more losses.

How to improve your odds of refinancing

If you’re still convinced that refinancing is the right move, how can you find a lender who is willing to go through with it while your home is still for sale?

The first step is to be honest. If your home is listed, it will show up on a multiple listings service (MLS) that the lender can easily cross-reference, so you shouldn’t try to hide it.

Beyond that, here are three steps you can take to improve your chances of getting approved for a mortgage refinance.

1. Take your home off the market

Most lenders will require that you remove your listing before they consider refinancing.

For cash-out refinance transactions, Fannie Mae, a government-sponsored enterprise that buys mortgages from lenders, requires that your property must be taken off the market before the loan is disbursed. And for limited cash-out refinance transactions, they require that the borrower confirm their intent to occupy the home.

In other words, for the most part you will not be allowed to refinance your mortgage if you are still planning to sell the home. You must have changed your mind, decided to hold onto it, and taken it off the market.

2. Write a letter of intent

Even if you do take your home off the market, lenders may still be wary of proceeding. In that case, a letter explaining your new intentions may help you secure the refinance you’re looking for.

According to Green, Fannie Mae requires borrowers to sign a letter indicating their intention to occupy the home as a primary residence. In other situations, you might write a letter explaining that you’ve decided to turn the home into a rental property rather than sell it.

Whatever the case, explaining your intention to hold onto the property, and providing evidence of that intention if possible, could help your case. For example, a copy of a lease agreement with a tenant could bolster your case that you are truly planning on using the property as a rental.

Again, it’s important to be honest. If you declare your intention to keep the home and then turn around and sell it right away, you could end up in a lot of trouble.

“If you misrepresent your intentions, you’ve committed mortgage fraud,” said Fleming. “The lender could sue you for damages and the federal government could prosecute you.”

3. Shop around

While most lenders will require that you take your home off the market and leave it off the market in order to refinance, some don’t have those restrictions.

“Banks or credit unions that retain some of their loans rather than sell them might be more willing,” said Fleming. “But only on higher-risk, higher-rate loans.”

If you shop around, you may be able to find a lender who’s willing to refinance even if you keep your home for sale. But there’s no guarantee, and you’ll likely end up with a more expensive loan that could hurt you in both the short and long term.

A good place to start shopping refi offers is through MagnifyMoney’s parent company, LendingTree’s mortgage marketplace.

The Bottom Line

If your home is already listed for sale, or if you plan on selling in the near future, refinancing is a difficult proposition. Many lenders won’t even offer a refinance unless you take your home off the market and those that will refinance often charge you higher interest rates.

In the end, it may be better to simply avoid refinancing if a sale is imminent.

But if you’ve had trouble selling your home and you’re having second thoughts, you can improve your chances of getting approved by taking your home off the market and refinancing in good faith.

Doing so could help you secure a lower monthly payment, a lower interest rate, or both, and free up a little extra cash flow for your other needs.

Advertiser Disclosure: The card offers that appear on this site are from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all card companies or all card offers available in the marketplace.

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Mortgage

Is Now the Best Time to Buy a Home?

Editorial Note: The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

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Mortgage applications increased by 7.8% in December 2017 from the previous year, according to the Mortgage Bankers Association. But the fact that more people are buying homes doesn’t necessarily mean it’s the best time for you.

If you’re trying to decide whether now is the right time to buy a home, it’s important to understand how the housing market works and whether you’re financially and emotionally ready to take on such a large commitment.

Here are some of the most important factors to consider.

A snapshot of the current housing market

There are several market forces that influence the overall affordability of housing, and can therefore affect your personal decision.

In this section, we’ll look at the current state of three main factors: mortgage rates, home prices, and inventory levels.

Mortgage rates are rising

As with the stock market, you can’t know for sure how mortgage interest rates will change over time. You can, however, make predictions based on some underlying factors.

According to Tendayi Kapfidze, chief economist at LendingTree, mortgage rates are significantly higher than they were six months ago. Indeed, the following chart from Freddie Mac shows a steady climb starting in September, followed by a sharp climb in rates more recently:

Kapfidze points to two factors that have helped push rates higher.

“The first thing is that the Federal Reserve, since September, has been reducing its holdings of Treasury securities and mortgage-backed securities,” he said.

The Federal Reserve began the program of buying up these holdings in response to the financial crisis that began a decade ago. The idea was to lower interest rates to encourage businesses to invest and help the economy grow.

Kapfidze says that this reduction in the Federal Reserve’s holdings lowers demand for Treasury bonds and mortgage-backed securities, “If you reduce the demand, the price falls,” he added, “which in this case means that interest rates go up.”

The second factor, according to Kapfidze, is the recent behavior of Congress, which passed both the Tax Cuts and Jobs Act and a sweeping budget bill recently.

“Both of those things are projected to increase the U.S. budget deficit pretty significantly,” said Kapfidze. “They’re going to be issuing a lot more Treasury bonds, and because they’re adding a lot of supply and we have a reduction in demand, that’s also pushing up the interest rates.”

Home prices are on the rise

If you thought home prices were high when the housing market bubble burst in 2007, take a look at how they’ve grown since the market recovered.

If you’re concerned that the market will see another correction soon, you might not want to risk getting caught up in it. It’s difficult to predict if and when a correction will happen, so it’s often not advisable to try to time the market.

One thing to keep in mind, though, is the correlation between interest rates and home prices.

“As mortgage rates go up, that does put some downward pressure on home prices, but it does it with a lag,” said Kapfidze. “If you were to run a correlation between mortgage rates going up this year and home prices three years from now, you’ll probably see a little slower appreciation in home prices.”

There are fewer homes available

While mortgage rates may not have an immediate impact on home prices, inventory levels can. Total housing inventory fell 11.4% in December 2017, according to the National Association of Realtors, and was 10.3% lower than the previous year.

With fewer homes on the market and growing demand, sellers have less competition and therefore more opportunity to increase prices. But Kapfidze doesn’t see that acting as a deterrent for homebuyers.

“Given the strength of demand in the housing market today, I think you’ll probably still see pretty strong growth in home sales this year,” he said.

The benefits of buying a home

Buying a home is a major financial commitment and should not be taken lightly. But it also comes with some significant benefits, both financial and otherwise, that may factor into your decision.

Tax breaks

The U.S. tax code allows homeowners to deduct the amount of mortgage interest and property taxes they pay each year from their taxable income. The catch is that you have to be able to itemize your deductions instead of taking the standard deduction.

With the new tax law in effect, the standard deduction has increased from $6,500 to $12,000 for single taxpayers and from $13,000 to $24,000 for married couples filing jointly. As a result, fewer homeowners find it worthwhile to itemize their deductions and therefore take advantage of the mortgage interest and property tax deductions.

You may also receive a tax break when you selling your home down the road. The IRS allows you to up to $250,000 in tax-free gains on your sale if you are single, and up to $500,000 if you are married filing jointly, assuming certain conditions are met.

So if, for example, you buy a house for $200,000 and sell it years later for $300,000, that $100,000 gain would be completely tax-free as long as you meet the eligibility requirements.

Equity

So long as home sales remain strong, a home is an appreciable asset, which means that its value typically grows over time. And every monthly payment you make increases the amount of the home that you actually own — your equity — which means that you are building wealth along the way.

Of course, growth isn’t guaranteed. As the U.S. real estate bubble burst a decade ago, the Case-Shiller 20-City Composite Home Price NSA Index fell for almost three years straight.

That said, the long-term upward trend is clear. According to the U.S. Census Bureau, the median home value grew from $30,600 in 1940 to $119,600 in 2000, adjusted for inflation.

All of which is to say that owning a home functions as a sort of forced savings program. By continually contributing money to an appreciable asset, you can build long-term wealth.

Predictable monthly costs

If you opt for a fixed-rate mortgage, your monthly payment is locked in for the length of your loan term. This is in contrast to renting, where your monthly payment can change every time you renew your lease.

That fixed cost can make budgeting and planning a lot easier. With that said, owning your house means that you’re on the hook for maintenance and repairs. These costs can be unpredictable, and sometimes quite high, which is one of the reasons why building an emergency fund can be so helpful.

More control

While homeownership can provide financial benefits, many people simply want the freedom to create a home that makes them happy.

As a homeowner, you don’t have to ask permission to paint the walls, replace the floor, add a room or get a pet. For the most part, you have complete control to do what you like.

Of course, this may mean spending more money on home improvements. But if it’s in pursuit of turning your house into a home, it may be worth the costs.

Running the numbers on buying vs. renting

The choice to buy or rent isn’t always an easy one, even if you’ve done your homework. But it’s always helpful to run the numbers to see which route is more likely to come out ahead.

You can play around with The New York Times’s Buy vs. Rent calculator to crunch the numbers.

It generally makes more sense to buy if you plan on living in the home for an extended period of time.

The less time you plan on staying in the home, and the greater the associated costs of your home are — such as interest rate, property taxes, insurance, and maintenance — the less likely it is that buying will be the better financial decision.

While there is no golden rule, there are certain variables that generally argue one way or the other in the buy vs. rent debate.

Here are some of the major considerations:

Even if you’re ready to take the next step toward buying a house, the process can be daunting, especially if you’re a first-time homebuyer.

As you begin the house-hunting process, here are some tips to help you stay on the right track.

1. Figure out how much you can afford

A mortgage is a long-term investment, so make sure your budget can handle both the monthly payment and all the other expenses that come with owning a home.

“You want to make sure to have a conservative budget, so if any curveballs are thrown at you like a lost job or big unexpected repair, you have the means to tackle them,” said Mike Schupak, CFP®, a fee-only financial planner and the founder of Schupak Financial Advisors in Jersey City, N.J.

You can use MagnifyMoney’s home affordability calculator to get a quick idea of your price range, then focus on homes within that range.

2. Research recent home sales in your area

Given that the housing market crashed not too long ago, and that average home prices have now risen above what they were before the crash, you might be worried about buying at the top of the market and suffering through another downturn.

Luckily, there are plenty of tools that allow you to research the value of recently sold homes in your area, which can help you gauge whether the home prices you see are fair.

Websites like Zillow.com and Realtor.com can be helpful places to start. Zillow allows you to search as many as three years back, and both sites allow you to filter based on a number of variables so that you can get as fair a comparison as possible.

But this is where a good realtor will really shine. Realtors have access to databases that go back even further, and a good realtor will understand how to evaluate that data, find the right comparisons and explain it all in a way that makes sense.

3. Determine how much you’ll put down

A larger down payment will reduce your monthly payment and potentially allow you to avoid PMI, but you have to weigh that against the savings you have available and your other financial needs.

Lucas Casarez, CFP®, a fee-only financial planner and the owner of Level Up Financial Planning in Fort Collins, Colo., says that a 20% down payment is preferred, but not a deal breaker. It typically allows you to avoid PMI and may allow you to secure a lower interest rate.

But putting 20% down isn’t always realistic, and there are plenty of mortgage programs that allow you to buy a home with less. You just need to weigh the pros and cons in light of your personal situation.

4. Get preapproved

You can get a pre-approval letter from a lender before even making an offer on a house. This letter says that the lender will likely loan you up to a certain amount of money, based on a set of assumptions.

And while this isn’t a loan offer or a guarantee, it both allows you to make an offer with more confidence and gives the seller more confidence that you will actually be able to follow through on your offer, increasing your odds of having it accepted.

5. Avoid applying for credit

Every time you apply for a credit card, loan or any other type of credit, the lender does a hard credit check that can temporarily knock a few points off your credit score.

It’s therefore wise to delay new credit activity until after you close on your mortgage in order to keep your credit score from dropping.

6. Get the right loan

There are many different types of mortgages, from conventional loans to non-conforming loans, to programs that allow you to put less than 20% down. You can get a fixed interest rate or an adjustable rate, and you can choose mortgage term that’s typically either 15 or 30 years.

There are many different factors to consider, and a good mortgage adviser can help you understand your options and make the right choice based on your personal needs.

7. Compare mortgage rates

Every mortgage lender has different criteria when underwriting their mortgages, so you have the opportunity to shop around to find the lowest interest rate available to you. You can use this tool from the Consumer Financial Protection Bureau to get a sense of the rates available in your area, and you can apply with several lenders to see what offers you qualify for.

MagnifyMoney’s parent company LendingTree also makes it easy to get quotes from lenders online, using this short online form.

And you don’t have to worry about hurting your credit score by making several applications. As long as they are all within a 45-day window, the credit bureaus will count multiple credit checks from multiple mortgage lenders as a single inquiry.

8. Make a strong but reasonable offer

Once you find the right house, you can work with your real estate agent to make a strong offer that’s within your budget.

At this point in the process, you may be confronted with competing bids, and it’s important not to get caught up in a bidding war that could put you in a difficult situation. You can potentially work with your realtor to make certainly reasonable concessions, but be prepared to walk away if the price gets too high.

The bottom line: Is it time for me to buy a house?

With so many market and financial factors to consider, it can be hard to figure out whether it truly is the right time to buy. Schupak’s advice is to focus on what you can control.

“Don’t try to time interest rates,” Schupak said. “Instead, focus on items like purchase price, expected maintenance cost, insurance, HOA fees and real estate taxes. A forecast miss on those items often turns out to be much more costly than a higher interest rate.”

Casarez encourages people to be conservative and wait until you have a solid foundation in place that can help you navigate the ups and downs of this big transition.

“Sometimes the monthly cost of owning a house can be a big jump, and it can cause a lot of stress,” said Casarez. “The best time to buy a home is when you’re financially and mentally ready to do so.”

Advertiser Disclosure: The card offers that appear on this site are from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all card companies or all card offers available in the marketplace.

Matt Becker
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Matt Becker is a writer at MagnifyMoney. You can email Matt here

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Personal Loans

Can I get an Unsecured Loan After Bankruptcy?

Editorial Note: The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

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If you’ve just gone through a bankruptcy, you might feel a little vulnerable financially. You’ve been promised a clean slate, but your credit score has taken a hit and it could take months or even years to get to a point where you can qualify for a loan that isn’t highly expensive.

You need credit to build credit though, and one way to start building your credit after you’ve gone through bankruptcy is through a personal loan.

Yes, it is possible to get a personal loan after bankruptcy. But in order to find one that isn’t predatory in nature, it’s important to understand where you stand, how to properly prepare, and where to look.

Part I: How personal loans after bankruptcy can help you build credit

As you work to get your credit back on track after bankruptcy, a personal loan could certainly help. That’s because the most important factor in your credit score is your payment history, and making on-time payments on your personal loan after bankruptcy helps establish a positive payment history.

What is a personal loan?

An unsecured personal loan is a loan that doesn’t require collateral that the lender can repossess if you default on your payments.

What are my odds of getting approved?

Many lenders don’t offer unsecured loans for people who have a bankruptcy on their record, but there are a handful who specialize in exactly this type of loan. The trick is finding one that isn’t predatory in nature.

“When a person files for bankruptcy, they are seeking a debt solution that results in partial or complete liquidation of the debt they owe,” says Bruce McClary, Vice President of communications for the National Foundation for Credit Counseling.

“This leads to a financial loss for their lenders,” he adds. “Because of that fact, and that the set of circumstances leading to their bankruptcy may not be completely resolved, lenders will continue to view bankruptcy filers as a risk.”

There are two types of consumer bankruptcy: Chapter 7 and Chapter 13. Each has a different impact on your credit and your chances of getting approved for after-bankruptcy loans.

Chapter 7 bankruptcy

With a Chapter 7 bankruptcy, you’re required to sell off certain assets to pay off eligible outstanding debts.

A Chapter 7 bankruptcy gives you more of a clean slate, so to speak, than a Chapter 13 bankruptcy. But it remains on your credit report for longer — up to 10 years, according to McClary.

McClary also warns that lenders may look less favorably on a Chapter 7 bankruptcy because it doesn’t involve a repayment plan like a Chapter 13 bankruptcy. As a result, it may be tougher to get a personal loan after Chapter 7 discharge.

You don’t have to wait the full 10 years for your credit score to improve though. As you start establishing positive credit habits, and as your bankruptcy moves further into the past, the positive habits will gain in importance and the negative impact of your Chapter 7 bankruptcy will fade. So the sooner you start rebuilding your credit, the better.

Chapter 13 bankruptcy

While a Chapter 7 bankruptcy eliminates your eligible debts entirely, a Chapter 13 bankruptcy calls for a reorganization of your debts and finances.

You’ll set up a repayment plan through the court system, typically over a three to five year period, during which you’ll make payments to a trustee who then distributes the payments to creditors who have filed claims against you. Unlike a Chapter 7 bankruptcy, Chapter 13 doesn’t require you to sell off any personal property to pay down your debts.

People typically opt for a Chapter 13 bankruptcy when they don’t meet the eligibility requirements for a Chapter 7 bankruptcy.

While you’re stuck making payments for a few years, however, a Chapter 13 bankruptcy won’t remain on your credit report as long as a Chapter 7 bankruptcy.

“Anyone who files and successfully completes a Chapter 13 can see the bankruptcy information on their credit report for seven years,” says McClary

And since it takes much longer than a Chapter 7 bankruptcy, which can be processed in months, McClary says that you may be able to apply for a loan before the bankruptcy is discharged.

But as with a Chapter 7 bankruptcy, your Chapter 13 bankruptcy won’t ruin your credit for the full seven years. If you manage to get approval for a loan during your repayment period, you can start establishing a positive payment history sooner rather than later.

Part II: Applying for a personal loan after bankruptcy

How to prepare your loan application

If you’re interested in getting a personal loan after bankruptcy, it’s critical that you present yourself in the best way possible.

Get a copy of your credit reports
You can get a free copy of your credit reports once per year from all three credit bureaus — Equifax, Experian, and TransUnion — through AnnualCreditReport.com. Once you have your credit reports, you can check to see if the information is accurate and up-to-date.

For example, if you filed Chapter 7 bankruptcy, make sure that all your eligible debts were included in the bankruptcy and that they’re now showing a zero balance. If you filed Chapter 13, check to see that your payments are being applied correctly.

If any information is inaccurate, you can file a dispute to have it corrected or removed from your credit report altogether.

Make sure your income is accurate
Your credit report and score are just two that factors lenders consider. In some cases, proving that you have sufficient income to repay a loan can make you appear less risky.

Your reportable income is based on your current income, so if you’ve received a raise recently, make sure to include that in your calculation. Also, include any other income that you have reasonable access to, such as cash you’ve earned from a side business or a spouse’s income.

Be prepared with the right documents to prove your income. This may include pay stubs, bank statements, a W-2, or tax returns.

Be ready to make your case
If your application gets denied off the bat, you may still have a chance to make your case. Be ready to explain what led you to declare bankruptcy and your commitment to building better credit habits. There’s no guarantee that doing this will overturn a denial, but it doesn’t hurt to try.

Part III: Shopping for an unsecured personal loan after bankruptcy

Finding a lender who’s willing to offer personal loans for discharged bankruptcies can be hard, but it may be worth the effort.

“Although lenders will view a recent bankruptcy filer as a risk, they may still be willing to approve them for financing,” says McClary. “Most lenders will offset the risk with higher interest rates and additional fees, which makes it costlier for the borrower.”

Here are a few options to consider.

Your bank

If you already have an established relationship with a community bank, you may have a better chance of getting approved, especially if you’ve been with the bank for years and know someone at the local branch.

Big banks often don’t specialize in personal loans after bankruptcy, however, so you might not find success going this route.

A local credit union

Credit unions are different from banks in that they’re not-for-profit organizations owned by their members. As a result, credit unions are generally more focused on serving the community than generating profits and may be more lenient with bad credit.

That said, credit unions often require that you become a member before you can apply for a loan. And if you’re a new member without a history with the credit union, it may be more difficult to secure a loan.

Online lenders

There are several online lenders that specialize in loans for people with bankruptcy or generally poor credit.

LendingTree, which owns MagnifyMoney, can help you find these lenders. If you fill out a short online form, you may be able to get some quotes from lenders based on a soft credit check. That way you can compare offers to determine which one best suits your needs and your budget.

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Peer-to-peer lenders

Lenders like LendingClub and Prosper are unique in that instead of lending you money directly, they act as an intermediary between individual lenders and individual borrowers.

Since some individual lenders may be willing to invest in higher-risk loans, you might have an opportunity to get approved even with a bankruptcy.

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Other options if you’re rejected for a personal loan

While you may be able to get an unsecured personal loan after bankruptcy, but there’s no guarantee you’ll be approved. Each lender has a different set of criteria, and they consider several factors before making a decision.

So, if you do end up getting denied, it’s important to know what your alternatives are. Here are some of the major options to consider.

Find a co-signer

While it can be difficult to get approved for a personal loan after bankruptcy on your own, you’ll have a much better chance if you can manage to find someone to cosign the loan with you.

This could be a family member or close friend. Keep in mind, however, that cosigning means that they’re lending more than just their good name. Your co-signer will be equally responsible for repaying the debt, and it could hurt their credit if you default.

You may want to avoid this option if you think that something could go wrong and harm your relationship.

Apply for a secured personal loan

If an unsecured personal loan isn’t available, you might have some luck putting up collateral for a secured personal loan. Some examples of eligible collateral include:

  • Vehicles
  • Real estate, such as equity in your home
  • Investments
  • Insurance policies

Before you choose this option, you should understand the risks involved. Your collateral may be worth more than the loan itself, and you could lose your collateral if you default, which could cause more financial problems.

Apply for a secured credit card

Secured credit cards are similar to secured personal loans in that you need to put up collateral to get approved. The difference is that your collateral is a cash deposit, typically equal to your desired credit limit.

Other than the security deposit, a secured credit card functions the same as a conventional credit card. One big benefit of using a secured card to rebuild credit is that as long as you pay off your balance in full each month, you don’t ever have to pay interest.

That said, some secured cards charge annual fees, as well as high APRs, so they’re not ideal if you plan to carry a balance.

Part IV: How to rebuild your credit after bankruptcy

As you’re working to get your credit back on track, it’s important to know how your actions affect your credit score.

Here’s a list of factors that FICO uses to calculate your credit score, along with how important they are:

  • Payment history (35% of your score)
  • Amounts owed (30%)
  • Length of credit history (15%)
  • Credit Mix (10%)
  • New credit (10%)

The most important thing you can do to boost your credit score is to make payments on time. By applying for an unsecured personal loan after bankruptcy, you can get an account with a lender who will report your monthly payments.

How much you owe is also important, so avoid borrowing more than you need. Consider applying for a secured credit card and maintaining a low balance. This will help you maintain a low credit utilization rate, which is an important element of the “amounts owed” factor.

Having both a secured credit card and unsecured personal loan can help diversify your credit mix, but you should be careful about submitting too many applications; too much new credit can hurt your score.

The bottom line

If you’re looking to rebuild your credit after a bankruptcy, using an unsecured personal loan can be a great way to re-establish a positive payment history.

It’s important to understand, however, that these unsecured personal loans can come with high interest rates. Do the math to make sure it’s worth the cost by considering the fees and interest involved, as well as your monthly payments.

It’s best to use a personal loan after bankruptcy if you have a legitimate need for the money. Borrowing and paying interest is a more costly way to build credit than, say, using a secured credit card and paying your balance in full each month, thereby avoid interest payments altogether.

Take your time to consider all of your options before making a decision. Shop around to make sure you’re getting the best deal. It’s not a guarantee that you’ll get a low interest rate, but you can avoid loans with the highest interest rates if you do it right.

Finally, don’t take it personally if you get denied. Lenders often don’t know you personally; all they see is what’s on the paper in front of them. So, if you do get denied, start working on an alternative and improve your credit to increase your chance of getting approved in the future.

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3% Down? Why Small Down Payment Mortgages Could Be a Bad Idea

Editorial Note: The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

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For prospective homeowners, the idea of saving up for a 20% down payment — usually tens of thousands of dollars — can often be paralyzing. As a result, small or no down payment mortgages are extremely attractive.

But as usual, taking a shortcut financially can come back to bite you. Mortgage loans that have a low-minimum down payment usually require extra fees or insurance to make it worth the lender’s while.

To determine whether a small down payment mortgage is right for you, it’s important that you know what you’re getting yourself into and how much it can cost you in the end.

Mortgages that require a small down payment

Small down payment mortgages are attractive primarily because they allow people to buy a home sooner than if they had to put a full 20% down.

This can be appealing for personal reasons since owning a house often makes it feel more like home. And it can occasionally be attractive for financial reasons, potentially saving you money compared with renting, particularly if you stay in the house for an extended period of time.

Additionally, there are several home loan programs that offer small or no down payment mortgages to those who qualify:

Veterans Affairs (VA) loans

These loans are insured by the U.S. Department of Veterans Affairs for certain veterans, service members, spouses and other eligible beneficiaries.

They don’t require a down payment or mortgage insurance but do charge a one-time funding fee of 0.5% to 3.3%, depending on the type of loan, the size of the down payment and the nature of your military service.

U.S. Department of Agriculture (USDA) loans

The U.S. Department of Agriculture insures home loans for low- to moderate-income homebuyers in eligible rural areas.

Like VA loans, there is no down payment for a USDA loan. But there is an upfront fee of 1% and an ongoing annual fee of 0.35%, both of which apply to purchases and refinances.

Federal Housing Administration (FHA) loans

Insured by the U.S. Department of Housing and Urban Development (HUD), borrowers can get an FHA loan with a down payment as low as 3.5%.

Additional fees include an upfront mortgage insurance premium of 1.75% and an annual mortgage insurance premium of 0.45% to 1.05%, depending on the type, size and length of the loan and the size of the down payment.

Conventional loans

Some mortgage lenders offer small down payment mortgages — as little as 3% down payment — to borrowers who qualify.

These loans, however, aren’t insured by a government agency, so the lender will require private mortgage insurance (PMI). The cost of PMI varies but is often between 0.5% and 1% of the loan amount. You can typically request to have your PMI dropped once you have at least 20% equity in the home.

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Learn more: Planning your down payment

The benefits of small down payment mortgages

These small and no-down payment mortgage options are designed for those with low- to moderate-incomes who either don’t have enough cash on hand for a large down payment or find it difficult to qualify for a conventional mortgage for credit reasons.

For example, you can get an FHA loan with a 3.5% down payment with a credit score as low as 580. VA loans technically don’t have any minimum credit score requirement, although you may still get denied if you don’t meet the lender’s financial criteria.

As a result, these small down payment mortgages are attractive because they make homeownership more accessible. You can save enough for a down payment much sooner than if you had to put the full 20% down, and you can secure a mortgage even if your credit isn’t perfect.

Why a small down payment could end up costing you more

Home loans with a small down payment are often billed as affordable options for homebuyers because of the fact that you don’t have to bring as much money to the table upfront. But the flipside is that you’ll likely spend more money over the life of your loan than if you waited until you had saved enough to make a larger down payment.

For example, let’s say you’re buying a $200,000 home, putting 3% down, and not rolling your closing costs into the loan. On a 30-year mortgage with a 4% interest rate, your monthly payment will consist of the following elements:

  • Principal: The amount of each payment that goes toward reducing your loan balance.
  • Interest: The amount of each payment that goes toward paying the interest on the loan.
  • PMI: Private mortgage insurance paid to a third party to protect the lender in case you default on your loan. For our example, we’ll assume a 0.75% rate.
  • Homeowners insurance: This covers certain damages to your home, the loss of personal belongings and covers your liability in the case that you accidentally injure someone or damage his or her property. Lenders typically require homeowners insurance and collect your payments in an escrow account, making payments to the insurance company for you. We’ll assume a $70 monthly insurance payment for our example.
  • Property tax: Your property tax rate will depend on your state and county. For the sake of simplicity, we’ll use a 1% tax rate for our example.

Using MagnifyMoney’s parent company, LendingTree’s online mortgage calculator, here’s how your monthly payment will break down:

  • Principal and interest: $926.19
  • PMI: $121.25
  • Homeowners insurance: $70
  • Property tax: $166.67

If you total these up, your monthly payment will be $1,284.11.

Now, let’s compare that with your monthly payment if you make a 20% down payment instead.

 

3% Down Payment

20% Down Payment

Principal and interest

$926.19

$763.86

PMI

$121.25

$0

Homeowners insurance

$70

$70

Property tax

$166.67

$166.67

Total Monthly Payment

$1,284.11

$1,000.53

That’s a savings of $283.58 per month, for a total of $102,088.80 over the life of the loan.

What you could do with the money you saved by making a bigger down payment

Even if you don’t plan on staying in the home for the full 30 years, having an extra few hundred dollars per month can make a big difference for your budget. Here are just a few things you can do with that additional cash.

  • Invest: Whether for retirement or some other long-term goal, investing is the best way to get your money to work for you.
  • Pay down debt: Student loans, credit cards, and other debts are easier to pay off when you have extra room in your budget.
  • Save: Saving ahead for home repairs and routine maintenance, as well as building an emergency fund to handle big, unexpected expenses.
  • Travel: More disposable income makes it easier to travel, whether you want to explore somewhere new or simply visit friends and family.
  • Home improvement: If your new house isn’t your dream home, you can use the monthly savings to work on renovations.

If you do plan on staying in your house for the life of the loan, that extra $102,088.80 can go a long way toward securing every part of your financial future.

How to decide if a low down payment mortgage is for you

While it’s generally better to make a bigger down payment, there are some situations in which a small down payment mortgage may be the better option.

You don’t plan on staying in the home very long

Over a 30-year period, you can save tens of thousands of dollars by opting for a higher down payment. But if you’re only planning on staying in the home for a few years, the savings won’t be nearly as high.

That said, it’s important to also consider the transaction costs.

“The cost of buying and then selling a home runs about 8% to 10% of the purchase price, depending on where you live,” said Casey Fleming, mortgage advisor and author of “The Loan Guide.” “Buying with a low down payment only makes sense if you plan on being in the home long enough to make back at least your acquisition and sale costs.”

You need the liquidity

Even if you have enough money to make a large down payment, you may not want to part with all of it. For example, you might prefer to keep your emergency fund intact rather than deplete it. Or you might want to keep some cash available for repairs. Or you might want to invest some of that money with the hope of getting a better rate of return.

“With a larger down payment, you’re taking money that’s liquid and making it illiquid,” said Dan Green, founder of Growella and the branch manager for Waterstone Mortgage in Pewaukee, Wis. “The only way to get to your money is to refinance, sell your home or take a line of credit. It’s very important that before making a large down payment that you have a sufficient emergency fund, a budget set aside for home repairs.”

Ways to build up to a larger down payment

If you’ve set a goal of making a 10% to 20% down payment on your next home purchase, now is the time to start getting your strategy in place. While it can sometimes take years to save that kind of money, there are a few things you can do to speed up the process.

Find extra cash to save

Sometimes the best way to reach a financial goal is a good mix of offense and defense.

On offense, consider finding ways to earn more money either by negotiating a raise, starting a side hustle, getting a second job or booking the occasional side gig.

On defense, create and maintain a budget to find areas where you can cut back. Set a monthly goal for how much you want to save, automate that savings and funnel any extra cash toward your down payment fund. Tools like You Need a Budget and Mint.com can help you create and execute this plan.

Pros

  • The opportunities to earn extra money are virtually endless.
  • You have control over how and where you spend your money.
  • Negotiating a raise at your current job can provide extra money without requiring extra work.
  • Starting a side hustle could bring in extra income long after you’ve reached your down payment goal.

Cons

  • These strategies can require more time than other options.
  • If you have a lot of debt and other essential expenses, cutting back can be hard.
  • Creating new habits and sticking to them can be difficult. You have to be committed for the long run.

Borrowing from family or friends

If a friend or family member is willing to loan you money, you might not have to spend time finding extra cash. You may even be lucky enough to receive the money as a gift — subject to federal gift tax rules — which would provide the money at essentially no cost to you.

However, if you are structuring it as a loan, Neal Frankle, a certified financial planner and the founder of Credit Pilgrim, recommends adhering to the current guidelines for Applicable Federal Rate (AFR), which specify minimum interest rates for various types of loans.

Pros

  • You’ll get into your new house sooner.
  • You can often get a lower interest rate from family or friends than you’d get from a lender.
  • You may have more flexibility with the repayment terms.

Cons

  • It can damage your relationship if something goes wrong.
  • Your family members or friends may not consider you trustworthy enough to loan money.
  • Not all mortgage lenders allow you to borrow your down payment.

Borrow from your 401(k)

Qualified retirement accounts like a 401(k) typically penalize you for taking withdrawals before you’ve reached retirement age.

But many 401(k) plans offer loan programs that allow you to borrow from your account balance, often with relatively low-interest rates even if you have poor credit. And if you are using the money in order to purchase a primary residence, you may be able to pay the loan back over a period of 25 years, as opposed to the standard 5-year term for most 401(k) loans.

Pros

  • You can get into your new house sooner.
  • 401(k) loans often have lower interest rates than a personal loan.
  • The interest you pay goes back into your 401(k) account rather than to a lender.

Cons

  • You’re forfeiting potential investment gains on the borrowed money.
  • If you leave your employer for any reason, your loan may be due within 90 days, putting you in a difficult financial position.
  • Not all 401(k) plans offer loan programs.
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The bottom line

There are certain situations where a small down payment mortgage might be a good idea. It can get you into a home sooner, and many federally-insured mortgage programs can minimize the costs and allow you to buy a home with less-than-perfect credit.

But in many cases, it’s better to go above and beyond the minimum down payment required. A larger down payment can save you money both in the short term and the long term, helping you invest more in your future financial security.

Making the right choice for your personal situation involves both running the numbers and taking your personal goals into account. If you do your due diligence, you’ll be in a better position to make a good decision.

Advertiser Disclosure: The card offers that appear on this site are from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all card companies or all card offers available in the marketplace.

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How to Choose the Right Type Of Debt Consolidation

Editorial Note: The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

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If you’re feeling buried by what you owe, debt consolidation could provide you with both immediate relief and a quicker path to debt-free.

Debt consolidation is the process of taking out a new loan and using that money to pay off your existing debt. It can help in a number of ways:

  • A lower interest rate could save you money and allow you to pay your debt off sooner
  • A longer repayment period could reduce your monthly payment
  • A single loan and single payment could be easier to manage than multiple loans

But debt consolidation isn’t without its potential pitfalls. First and foremost: Consolidating your debt doesn’t address the behavior that got you into trouble in the first place. If you’re in debt because of overspending, consolidating may actually exacerbate your problems by opening up new lines of credit that you can use to spend even more.

And every debt consolidation option has its own set of pros and cons that can make it a good fit or a bad one, depending on your circumstances.

This post explains all of those pros and cons. It should help you decide if debt consolidation is the right move for you, and, if so, which option is best.

Six Consolidation Options to Choose From

1. Credit card balance transfers

A credit card balance transfer is often the cheapest debt consolidation option, especially if you have excellent credit.

With this kind of transfer, you open a new credit card and transfer the balance on your existing card(s) to it. There is occasionally a small fee for the transfer, but if you have excellent credit, you can often complete the transfer for free and take advantage of 0 percent interest offers for anywhere from 12-21 months. None of the other debt consolidation options can match that interest rate.

There are some downsides, though:

  • You need a credit score of 700 or above to qualify for the best interest rate promotional periods.
  • Many cards charge fees of 3 to 5 percent on the amount that you transfer, which can eat into your savings.
  • Unless you cancel your old cards, you’re opening up additional borrowing capacity that can lead to even more credit card debt. Let’s put that another way: Now that you’ve paid off your old cards, you might be tempted to start using them again. (Don’t!)
  • If you don’t pay the loan back completely during the promotional period, your interest rate can subsequently soar. Some balance transfer cards also charge deferred interest, which can further increase the cost if you don’t pay your debt off in time.
  • This just isn’t for people with high levels of debt. Credit limits are relatively low compared with those tied to other debt consolidation options.

Given all of that, a credit card balance transfer is best for someone with excellent credit, relatively small amounts of debt and strong budgeting habits that will prevent them from adding to their burden by getting even further into debt.

2. Home equity/HELOCs

Home equity loans and home equity lines of credit (HELOCs) allow you to tap into the equity you’ve built in your home for any number of reasons, including to pay off some or all of your other debt.

The biggest benefit of this approach is that interest rates are still near all-time lows, giving you the opportunity to significantly reduce the cost of your debt. You may even be able to deduct your interest payments for tax purposes.

But again, there are perils. Here are some of the downsides to using a HELOC/home equity loan for debt consolidation:

  • Upfront processing fees. You need to watch out for upfront costs, which can eat into or even completely negate the impact of lowering your interest rate. You can run the numbers yourself here.
  • Long loan terms. You also need to be careful about extending your loan term. You might be able to reduce your monthly payment that way, but if you extend it too far, you could end up paying more interest overall. Home equity loans typically have terms of five to 15 years, while home equity lines of credit typically have 10-to-20-year repayment periods.
  • You could lose your home. Finally, you need to understand that these loans are secured by your home. Fail to make timely payments, and you put that home in jeopardy. This is why, though the interest rates are lower than with most other debt consolidation options, there’s also added risk.

Home equity loans and HELOCs are generally best for people who have built up significant equity in their home, can get a loan with minimal upfront costs, and either don’t have excellent credit or need to consolidate more debt than is possible with a simple balance transfer.

You can ask your current mortgage provider about taking out a home equity loan or line of credit. Also, compare offers at MagnifyMoney’s parent company, LendingTree, here and here.

3. Personal loans

Personal loans are unsecured loans, typically with terms of two to seven years. Interest rates typically range from 5 to 36 percent, depending on your credit score and the amount you borrow.

The advantage of a personal loan over a credit card balance transfer is that it’s easier to qualify. While you typically need a credit score of 700 for a balance transfer, you can get a personal loan with a credit score as low as 580. You can also qualify for larger loan amounts than the typical balance transfer.

And the big advantage over a home equity loan or line of credit is that the loan is not secured by your house. This means you can’t lose your home if you have trouble paying back the debt. You can also apply for and obtain a personal loan very quickly, often at a lower cost than a home equity loan or line of credit.

The biggest disadvantage is that your interest rate will likely be higher than either of those options. And if your credit score is low, you may not find a better interest rate than what you already have.

Generally, a personal loan is best for someone with a credit score between 600 and 700 who either doesn’t have home equity or doesn’t want to borrow against his or her home.

You can shop around for a personal loan at LendingTree. It’s important to compare offers to get the best debt consolidation loan possible.

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4. Banks and credit unions

In addition to shopping for a personal loan online, you can contact your local banks or credit unions to see what types of loan options offer.

This is more time-consuming than applying online, and it can be harder to compare a variety of loan options. But it may lead to a better interest rate, especially if you already have a good relationship with a local bank.

One strategy you might try: Get quotes online using a service like LendingTree’s, then take those quotes to the bank or credit union and give it a chance to do better.

This strategy is best for anyone who already has a good and lengthy banking relationship, particularly with a credit union. But if you’re going the personal-loan route, it’s worth looking into in any case.

You can find credit unions in your area here.

5. Borrowing from family or friends

If you’re lucky enough to have family members or friends who have ample assets and are happy to help, this could be the easiest and cheapest debt consolidation option.

With no credit check, no upfront fees and relatively lenient interest rate policies, this might seem like the best of all worlds.

Even so, there are some things to watch out for.

First: A loan fundamentally changes your relationship with the person from whom you borrow. No matter what terms you’re on now or how much you love and trust this person, borrowing money introduces the potential for the relationship to sour in a hurry.

Consequently, if you do want to go this route, you need to do it the right way.

Eric Rosenberg, the chief executive of Money Mola, an app that lets friends and family track loans and calculate interest, suggests creating a contract that outlines each party’s responsibilities, how much money will be borrowed, the timeline for repayment, the payment frequency and the interest rate. He also suggests using a spreadsheet to keep track of the payments made and the balance due.

And Neal Frankle, a certified financial planner and the founder of Credit Pilgrim, suggests adhering to the current guidelines for Applicable Federal Rate (AFR), which as of this writing require a minimum interest of 1.27 to 2.5 percent, depending on the length of the loan. Otherwise, you may have to explain yourself to the IRS and the person lending you the money could be charged imputed interest and have to pay additional taxes.

If you have a family member or a friend who is both willing and able to lend you money, and if your credit isn’t strong enough to qualify favorably for one of the other options above, this could be a quick and inexpensive way to consolidate your debt.

6. Retirement accounts

Employer retirement plans like 401(k)s and 403(b)s often have provisions that allow you to borrow from the accumulated sums, with repayment of the loan going right back into your account.

And while you can’t borrow from an IRA, you can withdraw up to the amount you’ve contributed to a Roth IRA at any time without penalties or taxes, and you can withdraw money from a traditional IRA early if you’re willing to pay both taxes and a 10 percent penalty (with a few exceptions).

The biggest advantage of taking the money out of a retirement account is that there is no credit check. You can get the money quickly, no matter what your credit history looks like. And with a 401(k) or 403(b), you are also paying interest back to yourself rather than giving it to a lender.

Still, while there are situations in which borrowing from an employer plan can make sense, most financial experts agree that this should be considered a last-resort debt consolidation option.

One reason is simply this: Your current debt is already hindering your ability to save for the future, while taking money out of these accounts will only exacerbate the problem. Another is that tapping a retirement account now may increase the odds that it will happen again.

“I’d stay away from a 401(k) loan like the plague,” says Ryan McPherson. McPherson, based in Atlanta, Ga., is a certified financial planner and fee-only financial planner and the founder of Intelligent Worth. “With no underwriting process, and because you’re not securing it with your house, you’re more likely to do it again in the future.”

If you are in dire straits and cannot use any of the other strategies above, then borrowing or withdrawing from a retirement account may be the only consolidation option you have. Otherwise, you are likely to be better off going another route.

Things to consider before picking a debt consolidation strategy

With all these debt consolidation options at your disposal, how do you choose the right one for your situation? To be sure, it’s a key decision: The right option will make it easier for you to pay your obligations, and less likely that you’ll fall back into debt.

Here are the biggest variables you should consider before making the choice:

  1. Have you fixed the cause of the debt? Until you’ve addressed the root cause of your debt, how can any consolidation option help you get and stay out of debt?
  2. How much debt do you have? Smaller debts can be handled through any of these options. Larger debts might rule out balance transfers or borrowing from relatives or friends.
  3. What are your interest rates? You need to be able to compare your current interest rates with the interest rates you’re offered by the options above, if you want to know whether you’re getting a good deal.
  4. What is your credit score? Your score determines eligibility for various debt consolidation options, as well as the quality of the offers you’ll receive. You can check your credit score here.
  5. When do you want to be debt-free? Shorter repayment periods will cost less but require a higher monthly payment. Longer repayment periods will cost more but with a lower monthly payment. With this in mind, you need to decide both what you want and what you can afford.
  6. Do you have home equity? This determines whether a home equity loan or line of credit is an option. If it is, you should decide if you’re comfortable putting your home on the line.
  7. Do you have savings? Could you use some of your savings, outside of retirement accounts, to pay off some or all of your debt? That may allow you to avoid debt consolidation altogether and save yourself some money.

So … what’s the best consolidation strategy?

Unfortunately, there is no single answer to this tough question. The right answer for you depends the specifics of the situation.

Your job is to know what you currently owe and understand the pros and cons of each option we’ve outlined above. In this fashion, you can make an informed choice, one that’ll get you out of debt now and keep you out of it forever.

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Mortgage

Understanding the FHA 203k Loan

Editorial Note: The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

Finding your dream home is hard.

Unless you have an unlimited budget, just about any home you buy will require compromise. The house that’s move-in ready might have fewer bedrooms than you’d like. The house that’s in the perfect location might need a lot of repairs.

Sometimes it feels like you’ll never be able to afford the house you truly want.

This is where the FHA 203(k) loan can be a huge help.

The FHA 203(k) loan is a government-backed mortgage that’s specifically designed to fund a home renovation. Whether you’re buying a new house that needs work or you want to upgrade your current home, this program can help you do it affordably.

Part I: Understanding the basics of 203(k) loans

What is a 203(k) loan?

The FHA 203(k) loan is simply an extension of the regular FHA mortgage loan program. The loan is backed by the federal government, which provides two big advantages:

  1. You can qualify for a down payment as low as 3.5 percent.
  2. You can quality with a credit score as low as 500, although better credit scores allow for better loan terms.

The additional benefit of the 203(k) loan over regular FHA loans is that it allows you to take out a single loan to finance both the purchase and renovation of a property, giving you the opportunity to build your dream home with minimal money down.

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How a 203(k) loan works

A 203(k) loan can be used for one of two purposes:

  1. Buying a new property that’s in need of renovations, from relatively minor improvements to a complete teardown and rebuild.
  2. Refinancing your existing home in order to fund repairs and improvements.

The maximum loan amount is determined by the general FHA mortgage limits for your area, and the minimum repair cost is $5,000. But as opposed to a conventional loan, in which your mortgage is limited to the current appraisal value of the property, a 203(k) loan bases the mortgage amount on the lesser of the following:

  • The current value of the property, plus the cost of the renovations
  • 110 percent of the appraised value of the property after the renovations are complete

In other words, it enables you to purchase a property that you otherwise might not be able to take out a mortgage on because the 203(k) loan factors in the value of the improvements to be made.

And it allows you to do so with a down payment as low as 3.5 percent, which can be especially helpful for first-time homebuyers who often don’t have as much cash to bring to the table.

All of this opens up a number of opportunities that would otherwise be off limits to many homebuyers. For Pamela Capalad, a fee-only certified financial planner and the founder of Brunch & Budget, it was the only way that she and her husband could afford a house in Brooklyn, N.Y., which is where they wanted to live.

“Finding out about the 203(k) loan opened us up to the idea of buying a house that needed to be renovated,” Capalad said. “It was by far the most budget-friendly way to do it.”

Of course, the opportunity comes with some additional costs.

According to Eamon McKeon, a New York-based renovation loan specialist, interest rates on a 203(k) loan are typically 0.25 to 0.375 percentage points higher than conventional loans.

They also require you to pay mortgage insurance. There is an upfront premium equal to 1.75 percent of the base loan amount, which is rolled into the mortgage. And there is an annual premium, paid monthly, that ranges from 0.45 to 1.05 percent, depending on the size of the loan, the size of the down payment, and the length of your mortgage.

Additionally, McKeon cautioned that unlike conventional loans, this mortgage insurance premium is applied for the entire life of the loan unless you put at least 10 percent down. The only way to get rid of it is to refinance.

What renovations can be financed through a 203(k) loan?

Source: iStock

A 203(k) loan allows you to finance a wide range of renovations, all the way from small improvements like kitchen appliance upgrades to major projects like completely tearing down and rebuilding the house.

The U.S. Department of Housing and Urban Development provides a list of eligible improvements:

The big stipulation is the work has to be done by a contractor. You are not allowed to do any of the work yourself (though there is an exception to this rule for people who have the skills to do it).

According to McKeon, this is the most challenging part of successfully executing a 203(k) loan. He said the vast majority of the projects he sees go south have contractor-related issues, from underestimating the bid, to being unresponsive, to not having the correct licenses.

On the flip side, one of the benefits is that the bank helps you manage costs. They put the money needed for the renovations into an escrow account and only release it to the contractor as improvements are made and inspected.

For Capalad and her husband, this arrangement was one of the draws of the 203(k) loan.

“I liked knowing that the contractor couldn’t suddenly gouge us,” she said. “He couldn’t quote $30,000 and then come back later and tell us we actually owed him $100,000.”

Capalad suggested using sites like Yelp and HomeAdvisor, as well as references from friends, to find a contractor. She said you should interview at least four to five people, get bids from each, and not necessarily jump at the cheapest bid.

“We made the mistake of immediately rejecting higher estimates,” said Capalad. “We realized later that their estimates were higher because they were more aware of what needed to be done and how the process would work.”

Who can use a 203(k) loan?

A 203(k) loan is available to anyone who meets the eligibility requirements (discussed below) and is looking to renovate a home.

It’s often appealing to first-time homebuyers, who are generally younger and therefore less likely to have the cash necessary for either a conventional mortgage or to fund the renovations themselves. But there is no requirement that you have to be a first-time homebuyer.

The program can also be used to finance either the purchase of a home in need of renovation or to refinance an existing mortgage in order to update your current home.

3 reasons to use a 203(k) loan

There are a few common situations in which a 203(k) loan can make a lot of sense:

  1. Expand your opportunity: In a hot market, move-in ready homes often sell quickly and for more than asking price. A 203(k) loan can open up the market for you, allowing you to choose from a wider range of properties knowing that you can improve upon any house you buy.
  2. Upgrade your current home: If you want to add a bedroom, redo your kitchen, or make any other improvements to your current home, a 203(k) loan allows you to refinance and fold the cost of those upgrades into your new mortgage with a smaller down payment than other options.
  3. Increase your home equity: McKeon argued that anyone taking out a regular FHA loan should at least consider turning it into a 203(k) loan. With the right improvements, you could increase the value of your home to the point that you have enough equity after the renovations to refinance into a conventional mortgage and remove or reduce your monthly mortgage insurance premium.

What it takes to qualify for a 203(k) loan

Qualifying for a 203(k) loan is much like qualifying for a regular FHA mortgage loan, but with slightly stricter credit requirements.

“FHA may allow FICO scores in the 500s, [but] banks/lenders have discretion or are required to only go so low on the score,” McKeon said.

Here are the major criteria you’ll have to meet:

  • You have to work with an FHA-approved lender.
  • The minimum credit score is 500, though McKeon said a credit score of 640 is typically needed in order to secure the smallest down payment of 3.5 percent.
  • You have to have sufficient income to afford the mortgage payments, which the lender determines by evaluating two years of tax returns.
  • Your total debt-to-income ratio typically cannot exceed 43 percent.
  • You must have a clear CAIVRS report, indicating that you are not currently delinquent and have never defaulted on any loans backed by the federal government. This includes federal student loans, SBA loans and prior FHA loans.
  • The current property value plus the cost of the renovations must fall within FHA mortgage limits.

The 203(k) loan application process

McKeon said the process of applying for a 203(k) loan generally looks like this:

  1. Get preapproved for a mortgage by an FHA-approved lender.
  2. Find a property you want to buy and submit an offer.
  3. Find an approved 203(k) consultant to inspect the property and create a write-up of repairs needed and the estimated cost.
  4. Interview contractors, receive estimates, and select one to be vetted and approved by your lender.
  5. Obtain an appraisal to determine the post-renovation value of your house.
  6. Provide other information and documentation as requested by your lender in order to finalize loan approval.

Property types eligible for 203(k) loans

A 203(k) loan can be used for any single-family home that was built at least one year ago and has anywhere from one to four units. You can use the loan to increase a single-unit property into a multi-unit property, up to the four-unit limit, and you can also use it to turn a multi-unit property into a single-unit property.

These loans can be used to improve a condominium, provided it meets the following conditions:

  • It must be located in an FHA-approved condominium project.
  • Improvements are generally limited to the interior of the unit.
  • No more than 5 units, or 25 percent of all units, in a condominium association can be renovated at any time.
  • After renovation, the unit must be located in a structure that contains no more than four units total.

A 203(k) loan can also be used on a mixed residential/business property if at least 51 percent of the property is residential and the business use of the property does not affect the health or safety of the residential occupants.

It’s worth noting that the property must be owner-occupied, so a 203(k) loan is not an option for a pure investment property.

Within those limits, a wide variety of properties could qualify. McKeon noted that when he writes these loans, he doesn’t care about the current condition of the property. Everything is based on the renovations to be done and the future condition of the property.

Part II: Types of 203(k) loans

Standard vs. streamline 203(k) loans

A streamline 203(k) loan, or limited 203(k) loan, is a version of the 203(k) loan that can be used for smaller renovations. While there is no limit to the renovation costs associated with a standard 203(k) loan — other than the general FHA mortgage limits — a streamline 203(k) can only be used for up to $35,000 in repairs. There is no minimum repair cost.

In return, you get an easier application process. While a standard 203(k) loan requires you to hire a HUD-approved 203(k) consultant to help manage the renovation process, a streamline 203(k) does not.

However, there are limits to the kind of work you can have done with a streamline 203(k) loan. You can review the list of allowed improvements here and the list of ineligible improvements here, but here’s a quick overview of what isn’t allowed with a streamline 203(k):

  • The improvements can’t be expected to take more than six months to complete.
  • The improvements can’t prevent you from occupying the property for more than 15 days during the renovation.
  • You cannot convert a single-unit home into a multi-unit home, or vice versa.
  • You cannot do a complete teardown.

So when does a streamline 203(k) loan make sense over a standard 203(k) loan? Here is when it’s worth considering:

  • The property requires less than $35,000 in repairs and otherwise falls within the requirements for an eligible renovation.
  • You are comfortable scoping the work, gathering contractor estimates, and supervising the renovations without the help of a consultant.
  • You don’t expect the renovations to require an extensive amount of time.
  • You like the idea of minimizing paperwork and otherwise shortening the entire process.

Part III: Is a 203(k) loan the best option for you?

Alternatives to a 203(k) loan

Of course, a 203(k) loan isn’t the only way to finance a renovation. Here are some of the alternatives.

Fannie Mae HomeStyle Renovation Mortgage

The Fannie Mae HomeStyle Renovation Mortgage is a conventional conforming mortgage that, like the 203(k) loan, is specifically designed to finance renovations.

The biggest drawback is that it requires a 5 percent down payment as opposed to 3.5 percent. That can potentially require you to bring a few thousand dollars more in cash to the table.

But McKeon says that if you can afford it, it’s usually a better option. The biggest reason is that your monthly private mortgage insurance (PMI) is typically less, and it automatically drops off once your loan-to-value ratio reaches 78 percent, as opposed to a 203(k) loan where the PMI generally lasts for the life of the loan.

Home equity loan

If you’re looking to renovate your current home, one option would simply be to take out a home equity loan that allows you to borrow against the equity you’ve already built up in your house.

The advantages over a 203(k) loan would generally be a potentially lower interest rate and fewer restrictions around what improvements are made and who makes them.

The big downside is that your loan is limited to your current equity. If you purchased your home relatively recently, or if your home has decreased in value, you may not have enough equity to finance a sizable improvement. And if you are looking to purchase and renovate a new home, the 203(k) loan is likely the better option.

Title I property improvement loan

Like 203(k) loans, Title I property improvement loans are backed by the federal government. They allow you to borrow up to $25,000 for single-family homes, and up to $12,000 per unit for multi-unit properties, to improve a home you currently own.

This loan could be preferable to a 203(k) loan if the improvements you want to make are relatively small, you don’t want to refinance or don’t have the money for a down payment, and/or you’d like to avoid some of the requirements and inspections surrounding a 203(k) loan.

Personal savings

If you have the savings to afford the renovations yourself, or if you can wait until you do have the savings, you could save yourself a lot of money by avoiding financing altogether.

Of course, this may or may not be realistic, depending on the type of project you’re considering. For smaller projects that aren’t urgent, this is a worthy candidate. For larger projects or those that need to be addressed immediately, financing may be the only way to make it happen.

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203(k) loans open up new opportunities

The FHA 203(k) loan isn’t for everybody. As Capalad found out the hard way, the money you save is often more than made up in sweat equity.

“I was making calls during my lunch break, and my husband was regularly stopping at the house to check in on things,” she said. “It really felt like our lives stopped for those 10 months.”

But McKeon said that if you have a creative eye and you’re willing to put in the work, you can end up with a much better home than you would have been able to purchase if you limited yourself to move-in ready properties, especially if you have a limited amount of cash to bring to the table.

In the end, it’s all about understanding the trade-offs and doing what’s right for you and your family. At the very least, the 203(k) loan expands the realm of possibility.

Advertiser Disclosure: The card offers that appear on this site are from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all card companies or all card offers available in the marketplace.

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Matt Becker is a writer at MagnifyMoney. You can email Matt here

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Small Business

Where to Find the Best Short-Term Business Loans in 2017

Editorial Note: The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

This guide will help you decide whether a short-term business loan is the right move for your company and how to get one that meets your needs.

You’ll learn:

Part I: Explaining Short-Term Business Loans

Whether you’re running your own business or you have a small team of employees, at the end of the day everything falls on your shoulders as a business owner. Every opportunity is yours to take. Every problem is yours to solve.

And the truth is that both opportunities and problems often require cash. Cash to buy more inventory. Cash to market your services. Cash to get you through a rough patch.

But sometimes the cash isn’t there when you need it. And that’s where a short-term business loan can be helpful.

Short-term business loans give you access to money quickly so that you can address your immediate need and pay the loan back with the revenue you earn over the next several months.

They essentially act as a bridge, allowing you to get from Point A to Point B even if you don’t have the cash on hand to do it yourself.

Recommended short-term business loan options

You have a lot of lenders to choose from when looking for a short-term business loan, and you should expect to spend some time sorting through them to find the best option for your personal needs.

Here are a few good options to get you started, and you can refer to the following guide for even more: 17 Options for Small Business Loans.

OnDeck

OnDeck
  • Website: https://www.ondeck.com/short-term-small-business-loan
  • Max loan amount = $500,000
  • Loan terms from 3 to 36 months
  • Annual interest rates start at 9.99%, with an average annual rate of 42.5%
  • 2.5 percent to 4 percent origination fee
  • Eligibility requirements
    • 1+ years in business. The average customer has been in business for 7 years.
    • $100,000+ annual gross revenue. The typical customer has $450,000+ annual gross revenue.
    • 500+ credit score. The majority of customers are at 660+.

RapidAdvance

RapidAdvance

National Funding

National Funding
  • Website: https://www.nationalfunding.com/solutions/short-term-business-loans
  • Max loan amount = $500,000
  • Loan terms from 6 to 12 months
  • Fees from 24 percent to 80 percent
  • Eligibility requirements
    • 1+ years in business
    • $100,000+ annual gross revenue
    • No defined minimum credit score, but representatives indicated that 465-480 was the lowest they have previously seen qualified
    • 3 months’ of bank statements

Kabbage

Kabbage

Compare small business loans online

These sites are great tools for small business owners looking to compare offers from several small business lenders all at once. They typically ask for some key info about your business and the type of loan you are looking for, then match you with lenders that fit your needs.

LendingTree

LendingTree

Website: https://www.lendingtree.com/business/small/

  • Eligibility requirements:
  • 1+ years in business
  • Credit score, revenue and other factors will be evaluated independently by each lender

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SBA Lender Match

Website: https://www.sba.gov/lendermatch

4 smart ways to use a short-term business loan

Source: iStock

Taking on debt should almost never be your first option, but there are a few situations in which a short-term business loan can make a lot of sense.

1. Buying More Inventory

Maybe you’re just starting out and you need to buy the inventory you’ll eventually sell. Or maybe you’re gearing up for a heavier sales period than usual.

Whatever the case, there are times where you need to buy more inventory and you don’t have the cash on hand to cover it. And as long as the expected revenue exceeds the amount you’re borrowing, plus interest, paying the loan off quickly shouldn’t be an issue.

2. Opening a new location

Opening a new store or a new office has the potential to grow your business by leaps and bounds. More locations means more opportunities to serve more people.

But it can cost a lot of money to open a new location. A loan can help you get it up and running, with the revenue produced by that new location being used to pay off the loan.

3. Hiring employees for the busy season

A lot of businesses need extra workers at certain points in the year. Think vacation destination restaurants in the summer or retail stores during the holidays.

A short-term business loan could help you hire those extra employees ahead of time, ensuring that you have all the help you need to take full advantage of the busy season.

4. Getting through a financial emergency

Unfortunately, business isn’t always booming. Sometimes you hit a rough patch, business is slow, and there isn’t enough revenue to cover all your expenses.

Taking on debt to address financial difficulties is risky. A loan is an additional financial burden that could make your problems worse.

But if you have good reason to expect a turnaround in the near future, a short-term loan could help you keep the lights on in the meantime.

Pros of Short-Term Business Loans

While a short-term business loan isn’t always the right solution, these loans do have a few advantages over other forms of financing:

  • Fast approval process – Certain online lenders will issue approval in just a few hours and deposit the money in your account in as little as 24 hours. If you need money fast, that could be the way to go.
  • Build your business credit – Short-term business loans are often available to businesses with little to no credit history. This both allows you to borrow money when other avenues are unavailable to you and to build a credit history that makes it easier to qualify for bigger loans down the line.
  • Take advantage of business opportunities – Because of the fast approval process and less stringent credit requirements, short-term business loans often allow you to take advantage of business opportunities that otherwise wouldn’t be available to you. This can sometimes make the difference between a business that fails and one that succeeds.
  • Match your borrowing needs – It doesn’t make sense to take out a 10-year loan if you just need help buying inventory you’ll sell in the next few months. Getting a short-term loan allows you to get the money you need and pay it back quickly so that it isn’t a burden any longer than it needs to be.

Cons of Short-Term Business Loans

While short-term business loans can be helpful in the right situations, they have a few characteristics that should make you think twice before taking them out:

  • Typically smaller loan amounts – Many short-term business loans are capped at $500,000 or less. If you’re in need of more than that, you may need to find a different form of financing.
  • Higher APR – Short-term loans typically have higher interest rates than longer term loans that come with longer application processes and stricter eligibility requirements. You’re paying the interest over a shorter time period, but it can still be an expensive way to access money.
  • Could be subject to daily/weekly payments – Shorter loans also come with more frequent payments. Many lenders require daily repayment, and even weekly repayment could be difficult if you won’t get the revenue right away.
  • Can lead to spending beyond your means – Due to the ease and speed with which you can obtain these loans, there’s a risk of developing a dependency upon debt that leads you to spending more than your business can truly afford. While debt can be helpful on occasion, it is not a sustainable way to run a business.

Short-term loan vs. line of credit

A line of credit is a popular alternative to taking out a short-term business loan, and there are situations in which it can be the better option.

A line of credit is an amount of money that a lender makes available to you to borrow. But unlike a loan, you don’t receive the entire amount right away. Instead, you are allowed to borrow money as you need it, up to the maximum amount, and you only pay interest on the amount you have actually borrowed.

According to Cathy Derus, CPA, a financial planner and the founder of Brightwater Financial in Chicago, the main advantage of a line of credit is the flexibility it provides. You borrow only what you need when you need it, allowing you to more precisely match your debt with your expenses.

The flip side, Derus says, is that a line of credit typically comes with a higher interest rate. If you are fairly certain of the amount of money you need, a short-term loan often allows you to borrow it at a lower cost.

Interest rates always depend on the lender you use and the specifics of the situation, so these aren’t hard and fast rules. But generally you can approach this decision like this:

  • If you’re unsure of the amount of money you need, or if you don’t need it all at once, the flexibility a line of credit provides may be worth the extra cost.
  • If you have a specific amount of money you need right now, a short-term loan may be the cheaper option.

PART II: Qualifying for a Short-Term Business Loan

Source: iStock

What it takes to qualify for a short-term business loan

Every lender has a different set of standards and will evaluate your business a little differently. But Derus says that there are three main factors that almost all lenders consider when deciding whether to offer you a loan, and on what terms:

  1. Time in business – Businesses that have been around for a longer period of time are less likely to fail and are therefore considered less risky. Older businesses are therefore generally able to qualify for larger loans at preferable rates.
  2. Credit history – Just like applying for a personal loan, lenders prefer long credit histories that show consistent, on-time payments. One of the benefits of short-term business loans is that you can often qualify without an extensive business credit history, but in that situation your personal credit will be scrutinized more closely and you may be held personally liable for the loan if the business can’t pay it back.
  3. Financial health of your business – The lender will look at bank statements and financial reports like profit and loss statements and your balance sheet to make sure that your company has the financial resources to pay back the loan. Most lenders specify a minimum gross revenue in order to qualify.

Lenders may also look at things like the industry you’re in, the amount of equity you personally have in the company, other debts or liens against the company, and even your business plan so they can feel confident you’ll use the money well.

Questions to ask before shopping for a short-term loan

Given those criteria, how can you put yourself in the best position possible to qualify for a favorable short-term business loan? Here a few questions you can ask yourself:

  • How long have you owned your business? The longer you’ve been in business, the more likely it is that you’ll be able to borrow the money you need at a reasonable cost.
  • Do you have organized and consistent financial reports? You’ll need to provide these to the lender during the application process, so you’ll want to make sure you have them ready and that they are accurate.
  • Do you have the revenue needed to pay back the loan? In addition to the lender’s evaluation of your revenue, you need to be confident yourself that you’ll have the money to pay back the loan quickly.
  • What is your company’s credit history? A strong and extensive credit history will make it easier to qualify for a loan. Minimal credit history means your personal credit will be more important. A negative credit history will make it harder to qualify.
  • What is your personal credit history? Even with minimal business credit history, you can often qualify for a short-term business loan if your personal credit history is strong.
  • Do you have other loans or obligations? Your credit utilization is the amount of debt you currently have compared to the amount of credit you have available to you, and a low credit utilization rate is one of the big keys to a good credit score. Loans and other financial obligations can not only hurt your credit score, but they can make you more risky in the lender’s eyes because you have multiple debts to pay back.
  • Do you have a relationship with any particular bank? A strong and extensive history with a particular bank might make it easier to borrow money on preferable terms.
  • Do you qualify for any government loans? The government offers lending programs to companies in specific situations. If you qualify, you may be able to borrow on more favorable terms than you would through private lenders.

How to determine what type of business loan you need

Finding the right short-term business loan for your needs requires some work on your part. Your job is first to understand your need, and second to find the loan that matches that need at the lowest cost possible.

Here’s a step-by-step process you can follow:

  1. Figure out how much money you need – You don’t want to borrow more than you need, but you also don’t want to come up short. In addition, the amount of money you need will affect the lender you choose, as different lenders have different maximum loan amounts.
  2. Determine when you need the money – Do you need it right away or can you afford to wait? The more time you have, the more options you’ll have available to you, as some of the loans with better terms require a longer application process.
  3. Determine when you’ll be able to pay back the loan – When will you have the revenue to pay back the loan? This will help determine how long your loan term needs to be.
  4. Can you afford to make daily or weekly payments? Short-term loans often require daily or weekly payments, so you need to make sure you’ll be able to make them.
  5. Check your business credit history – Business credit scores range from 0 to 100, with the SBA noting that 75 or above is the ideal range. You can research your business’s credit history through Experian and Dun & Bradstreet.
  6. Check your personal credit history – You can pull your credit history for free once per year from annualcreditreport.com. And you can use this guide to get a sense for your credit score. A stronger credit history and higher credit score will lead to better loans.
  7. Prepare your financial reports – You should have well-organized bank statements, a profit and loss statement, and a balance sheet ready to provide during the application process. If you haven’t been keeping your books up to date, you might want to obtain the help of a CPA to make sure everything is done correctly.
  8. Evaluate alternatives to a short-term loan – There are alternatives to taking out a short-term loan, such as taking out a line of credit or utilizing a small business credit card. Make sure that a loan is truly the best option before proceeding.
  9. Reach out to the bank you already do business with – The bank you already work with may be your best bet for favorable terms, especially if you’ve had a long and positive relationship. Reach out to them first to see what they’re able to offer.
  10. Research local credit unions – Credit unions are member-owned and therefore often offer better deals than the big banks. Search for credit unions in your area and reach out to see what types of loans they offer and whether you qualify for membership.
  11. Apply with online lenders – Online lenders often offer shorter applications, quicker approvals, and better user experiences, but those benefits often come at the cost of higher interest rates. If you need money quickly, or if your credit isn’t ideal, these may be your best option. Either way, it’s worth applying to see what you qualify for. To compare offers for small business loans from various lenders, check out MagnifyMoney parent company LendingTree.com’s small business offer tool. 
  12. Compare the offers you received – Once you’ve shopped around, you can compare the loan offers you’ve received both to each other and to your borrowing needs. You should compare them along variables like the amount of money being offered, the interest rate, the frequency and amount of payments required, and the overall length of the loan, along with any other terms and conditions each loan comes with.
  13. Make a final decision – At this point you should be ready to make a final decision. And remember, not taking out a loan is still an option at this point, especially if none of the offers were exactly what you were looking for.

Alternatives to a short-term business loan

While a short-term business loan can be invaluable in the right situations, it isn’t your only option when it comes to financing your needs. Here are a few more to consider:

  • Future revenue – If you can afford to wait and you expect revenue to be coming in soon, you may be better using that future revenue to finance your project yourself. There’s no application process and no interest to pay.
  • Line of credit – As discussed above, a line of credit is a good option when you’re unsure how much money you’ll need and when you need it. You can secure the line of credit and simply borrow the money as needed, with the likely trade-off of borrowing at a higher interest rate.
  • Business credit card – There are a number of small business credit cards available, some of which provide a promotional period with 0% interest. If your borrowing needs are relatively small and you can qualify for these cards, you may be able to borrow the money cost-free.
  • Personal line of credit – If you can’t qualify for a business line of credit, you still may be able to qualify for a personal line of credit. Derus warns against this option, though, since it blurs the line between you and your business, which can lead to you being personally liable for your business’s obligations. And she warns about following all relevant tax laws, such as calculating imputed interest, when using personal money in your business that you plan to pay back to yourself.

Advertiser Disclosure: The card offers that appear on this site are from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all card companies or all card offers available in the marketplace.

Matt Becker
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Matt Becker is a writer at MagnifyMoney. You can email Matt here

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Ultimate Guide to Maximizing Your 401(k)

Editorial Note: The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

You’re probably familiar with the basics of a 401(k).

You know that it’s a retirement account and that it’s offered by your employer. You know that you can contribute a percentage of your salary and that you get tax breaks on those contributions. And you know that your employer may offer some type of matching contribution.

But beyond the basics, you may have some confusion about exactly how your 401(k) works and what you should be doing to maximize its benefits.

That’s what this guide is going to show you. We’ll tell you everything you need to know in order to maximize your 401(k) contributions.

The 4 Types of 401(k) Contributions You Need to Understand

When it comes to maximizing your 401(k), nothing you do will be more important than maximizing your contributions.

Because while most investment advice focuses on how to build the perfect portfolio, the truth is that your savings rate is much more important than the investments you choose. Especially when you’re just starting out, the simple act of saving more money is far and away the most effective way to accelerate your path toward financial independence.

There are four different ways to contribute to your 401(k), and understanding how each one works will allow you to combine them in the most efficient way possible, adding more money to your 401(k) and getting you that much closer to retirement.

1. Employee Contributions

Employee contributions are the only type of 401(k) contribution that you have full control over and are likely to be the biggest source of your 401(k) funds.

Employee contributions are the contributions that you personally make to your 401(k). They’re typically set up as a percentage of your salary and are deducted directly from your paycheck.

For example, let’s say that you are paid $3,000 every two weeks. If you decide to contribute 5% of your salary to your 401(k), then $150 will be taken out of each paycheck and deposited directly into your 401(k).

There are two different types of employee contributions you can make to your 401(k), each with a different set of tax benefits:

  1. Traditional contributions – Traditional contributions are tax-deductible in the year you make the contribution, grow tax-free while inside the 401(k), and are taxed as ordinary income when you withdraw the money in retirement. This is just like a traditional IRA. All 401(k)s allow you to make traditional contributions, and in most cases your contributions will default to traditional unless you choose otherwise.
  2. Roth contributions – Roth contributions are NOT tax-deductible in the year you make the contribution, but they grow tax-free while inside the 401(k) and the money is tax-free when you withdraw it in retirement. This is just like a Roth IRA. Not all 401(k)s allow you to make Roth contributions.

For more on whether you should make traditional or Roth contributions, you can refer to the following guide that’s specific to IRAs but largely applies to 401(k)s as well: Guide to Choosing the Right IRA: Traditional or Roth?

Maximum personal contributions

The IRS sets limits on how much money you can personally contribute to your 401(k) in a given year. For 2017, employee contributions are capped at $18,000, or $24,000 if you’re age 50 or older. In subsequent sections we’ll talk about how much you should be contributing in order to maximize these contributions.

2. Employer Matching Contributions

Many employers match your contributions up to a certain point, meaning that they contribute additional money to your 401(k) each time you make a contribution.

Employer matching contributions are only somewhat in your control. You can’t control whether your employer offers a match or the type of match they offer, but you can control how effectively you take advantage of the match they do offer.

Taking full advantage of your employer match is one of the most important parts of maximizing your 401(k). Skip ahead to this section to learn more on how to maximize your employer match.

3. Employer Non-Matching Contributions

Non-matching 401(k) contributions are contributions your employer makes to your 401(k) regardless of how much you contribute. Some companies offer this type of contribution in addition to, or in lieu of, regular matching contributions.

For example, your employer might contribute 5% of your salary to your 401(k) no matter what. Or they might make a variable contribution based on the company’s annual profits.

It’s important to note that these contributions are not within your control. Your employer either makes them or not, no matter what you do.

However, they can certainly affect how much you need to save for retirement, since more money from your employer may mean that you don’t personally have to save as much. Or they could be viewed as additional free savings that help you reach financial independence even sooner.

4. Non-Roth After-Tax Contributions

This last type of 401(k) contribution is rare. Many 401(k) plans don’t even allow this type of contribution, and even when they do, these contributions are rarely utilized.

The big catch is again that most 401(k) plans don’t allow these contributions. You can refer to your 401(k)’s summary plan description to see if it does.

And even if they are allowed, it typically only makes sense to take advantage of them if you’re already maxing out all of the other retirement accounts available to you.

But if you are maxing out those other accounts, you want to save more, and your 401(k) allows these contributions, they can be a powerful way to get even more out of your 401(k).

Here’s how they work:

Non-Roth after-tax 401(k) contributions are sort of a hybrid between Roth and traditional contributions. They are not tax-deductible, like Roth contributions, which means they are taxed first and then the remaining money is what is contributed to your account. The money grows tax-free while inside the 401(k), but the earnings are taxed as ordinary income when they are withdrawn. The contributions themselves are not taxed again.

A quick example to illustrate how the taxation works:

  • You make $10,000 of non-Roth after-tax contributions to your 401(k). You are not allowed to deduct these contributions for tax purposes.
  • Over the years, that $10,000 grows to $15,000 due to investment performance.
  • When you withdraw this money, the $10,000 that is due to contributions is not taxed. But the $5,000 that is due to investment returns — your earnings — is taxed as ordinary income.

This hybrid taxation means that on their own non-Roth after-tax 401(k) contributions are typically not as effective as either pure traditional or Roth contributions.

But they can be uniquely valuable in two big ways:

  1. You can make non-Roth after-tax contributions IN ADDITION to the $18,000 annual limit on regular employee contributions, giving you the opportunity to save even more money. They are only subject to the $54,000 annual limit that combines all employee and employer contributions made to a 401(k)..
  2. These contributions can be rolled over into a Roth IRA, when you leave your company or even while you’re still working there. And once the money is in a Roth IRA, the entire balance, including the earnings, grows completely tax-free. This contribution rollover process has been coined the Mega Backdoor Roth IRA, and it can be an effective way for high-income earners to stash a significant amount of tax-free money for retirement.

How to Maximize Your 401(k) Employer Match

With an understanding of the types of 401(k) contributions available to you, it’s time to start maximizing them. And the very first step is making sure you’re taking full advantage of your employer match.

Simply put, your 401(k) employer match is almost always the best investment return available to you. Because with every dollar you contribute up to the full match, you typically get an immediate 25%-100% return.

You won’t find that kind of deal almost anywhere else.

Here’s everything you need to know about understanding how your employer match works and how to take full advantage of it.

How a 401(k) Employer Match Works

While every 401(k) matching program is different, and you’ll learn how to find the details of your program below, a fairly typical employer match looks like this:

  • Your employer matches 100% of your contribution up to 3% of your salary.
  • Your employer also matches 50% of your contribution above 3% of your salary, up to 5% of your salary.
  • Your employer does not match contributions above 5% of your salary.

To see how this works with real numbers, let’s say that you make $3,000 per paycheck and that you contribute 10% of your salary to your 401(k). That means that $300 of your own money is deposited into your 401(k) as an employee contribution every time you receive a paycheck, and your employer matching contribution breaks down like this:

  1. The first 3% of your contribution, or $90 per paycheck, is matched at 100%, meaning that your employer contributes an additional $90 on top of your contribution.
  2. The next 2% of your contribution, or $60 per paycheck, is matched at 50%, meaning that your employer contributes an additional $30 on top of your contribution.
  3. The next 5% of your contribution is not matched.

All told, in this example, your employer contributes an extra 4% of your salary to your 401(k) as long as you contribute at least 5% of your salary. That’s an immediate 80% return on investment.

That’s why it’s so important to take full advantage of your 401(k). There’s really no other investment that provides such an easy, immediate, and high return.

How to Find Your 401(k) Employer Matching Program

On a personal level, taking full advantage of your 401(k) employer match is simply a matter of contributing at least the maximum percent of salary that your employer is willing to match. In the example above that would be 5%, but the actual amount varies from plan to plan.

So your job is to find out exactly how your 401(k) employer matching program works, and the good news is that it shouldn’t be too hard.

There are two main pieces of information you’re looking for:

  1. The maximum contribution percentage your employer will match – This is the amount of money you’d need to contribute in order to get the full match. For example, your employer might match your contribution up to 5% of your salary as in the example above, or it could be 3%, 12%, or any other percentage. Whatever this maximum percentage is, you’ll want to do what you can to contribute at least that amount so that you get the full match.
  2. The matching percentage – Your employer might match 100% of your contribution, or they may only match 50%, or 25%, or some combination of all of the above, and this has a big effect on the amount of money you actually receive. For example, two companies might both match up to 5% of your salary, but one might match 100% of that contribution, and one might only match 25% of it. Both are good deals, but one is four times as valuable.

With those two pieces of information in hand, you’ll know how much you need to contribute in order to get the full match and how much extra money you’ll be getting each time you make that contribution.

As for where to find this information, the best and most definitive source is your 401(k)’s summary plan description, which is a long document that details all the ins and outs of your plan. This is a great resource for all sorts of information about your 401(k), but you can specifically look for the word “match” to find the details on your employer matching program.

And if you have any trouble either finding the information or understanding it, you can reach out to your human resources representative for help. You should be able to find their contact information in the summary plan description.

Two Big Pitfalls to Avoid When Maximizing Your 401(k) Employer Match

Your 401(k) employer match is almost always a good deal, but there are two pitfalls to watch out for: vesting and front-loading contributions. Both of these could either diminish the value of your employer match or cause you to miss out on getting the full match.

Pitfall #1: Vesting

Clock time deadline

Employer contributions to your 401(k) plan, including matching contributions, may be subject to something called a vesting schedule.

A vesting schedule means that those employer contributions are not 100% yours right away. Instead, they become yours over time as you accumulate years of service with the company. If you leave before your employer contributions are fully vested, you will only get to take some of that money with you.

For example, a common vesting schedule gives you an additional 20% ownership over your 401(k) employer contributions for each year you stay with the company. If you leave before one year, you will not get to keep any of those employer contributions. If you leave after one year, you will get to keep 20% of the employer contributions and the earnings they’ve accumulated. After two years it will be 40%, and so on until you’ve earned the right to keep 100% of that money after five years with the company.

Three things to know about vesting:

  1. Employee contributions are never subject to a vesting schedule. Every dollar you contribute and every dollar that money earns is always 100% yours, no matter how long you stay with your company. Only employer contributions are subject to vesting schedules.
  2. Not all companies have a vesting schedule. In some cases you might be immediately 100% vested in all employer contributions.
  3. There is a single vesting clock for all employer contributions. In the example above, all employer contributions will be 100% vested once you’ve been with the company for five years, even those that were made just weeks earlier. You are not subject to a new vesting period with each individual employer contribution.

A vesting schedule can decrease the value of your employer match. A 100% match is great, but a 100% match that takes five years to get the full benefit of is not quite as great.

Still, in most cases it makes sense to take full advantage of your employer match, even if it’s subject to a vesting schedule. And the reasoning is simply that the worst-case scenario is that you leave your job before any of those employer contributions vest, in which case your 401(k) would have acted just like any other retirement account available to you, none of which offer any opportunity to get a matching contribution.

However, there are situations in which a vesting schedule might make it better to prioritize other retirement accounts before your 401(k). In some cases, your 401(k) employer contributions might be 0% vested until you’ve been with the company for three years, at which point they will become 100% vested. If you anticipate leaving your current employer within the next couple of years, and if your 401(k) is burdened with high costs, you may be better off prioritizing an IRA or other retirement account first.

You may also want to consider your vesting schedule before quitting or changing jobs. It certainly shouldn’t be the primary factor you consider, but if you’re close to having a significant portion of your 401(k) vest, it may be worth waiting just a little bit longer to make your move.

You can find all the details on your 401(k) vesting schedule in your summary plan description. And again you can reach out to your human resources representative if you have any questions.

Pitfall #2: Front-Loading Contributions

In most cases, it makes sense to put as much money into your savings and investments as soon as possible. The sooner it’s contributed, the more time it has to compound its returns and earn you even more money.

But the rules are different if you’re trying to max out your 401(k) employer match.

The reason is that most employers apply their maximum match on a per-paycheck basis. That is, if your employer only matches up to 5% of your salary, what they’re really saying is that they will only match up to 5% of each paycheck.

For a simple example, let’s say that you’re paid $18,000 twice per month. So over the course of an entire year, you make $432,000.

In theory, you could max out your annual allowed 401(k) contribution with your very first paycheck of the year. Simply contribute 100% of your salary for that one paycheck, and you’re done.

The problem is that you would only get the match on that one single paycheck. If your employer matches up to 5% of your salary, then they would match 5% of that $18,000 paycheck, or $900. The next 23 paychecks of the year wouldn’t get any match because you weren’t contributing anything. And since you were eligible to get a 5%, $900 matching contribution with each paycheck, that means you’d be missing out on $20,700.

Now, most people aren’t earning $18,000 per paycheck, so the stakes aren’t quite that high. But the principle remains the same.

In order to get the full benefit of your employer match, you need to set up your 401(k) contributions so that you’re contributing at least the full matching percentage every single paycheck. You may be able to front-load your contributions to a certain extent, but you want to make sure that you stay far enough below the annual $18,000 limit to get the full match with every paycheck.

Now, some companies will actually make an extra contribution at the end of the year to make up the difference if you contributed enough to get the full match but accidentally missed out on a few paychecks. You can find out if your company offers that benefit in your 401(k)’s summary plan description.

But in most cases you’ll need to spread your contributions out over the entire year in order to get the full benefit of your employer match.

When to Contribute More Than Is Needed for Your Employer Match

Maxing out your 401(k) employer match is a great start, but there’s almost always room to contribute more.

Using the example from above, the person with the $3,000 per-paycheck salary would max out his or her employer match with a 5% contribution. That’s $150 per paycheck. Assuming 26 paychecks per year, that individual would personally contribute $3,900 to his or her 401(k) over the course of a year with that 5% contribution.

And given that the maximum annual contribution for 2017 is $18,000 ($24,000 if you’re 50+), he or she would still be eligible to contribute an additional $14,100 per year. In fact, this individual would have to set his or her 401(k) contribution to just over 23% in order to make that full $18,000 annual contribution.

3 big questions to answer:

  1. Do you need to contribute more in order to reach your personal goals?
  2. Can you afford to contribute more right now?
  3. If the answer is yes to both #1 and #2, should you be making additional contributions to your 401(k) beyond the employer match, or should you be prioritizing other retirement accounts?

Questions #1 and #2 are beyond the scope of this guide, but you can get a sense of your required retirement savings here and here.

Question #3 is what we’ll address here. If you’ve already maxed out your employer match and you want to save more money for retirement, should you prioritize your 401(k) or other retirement accounts?

Let’s dive in.

What Other Retirement Accounts Are Available to You?

Your 401(k) is almost never the only retirement account available to you. Here are the other major options you might have.

IRA

An IRA is a retirement account that you set up on your own, outside of work. You can contribute up to $5,500 per year ($6,500 if you’re 50+), and just like with the 401(k) there are two different types:

  1. Traditional IRA – You get a tax deduction on your contributions, your money grows tax-free inside the account, and your withdrawals are taxed as ordinary income in retirement.
  2. Roth IRA – You do not get a tax deduction on your contributions, but your money grows tax-free and can be withdrawn tax-free in retirement.

You can read more about making the decision between using a Roth IRA or a traditional IRA here: Guide to Choosing the Right IRA: Traditional or Roth?

The big benefit of IRAs is that you have full control over the investment company you use, and therefore the investments you choose and the fees you pay. While some 401(k)s force you to choose between a small number of high-cost investments, IRAs give you a lot more freedom to choose better investments.

The only catch is that there are income limits that may prevent you from being allowed to contribute to an IRA or to deduct your contributions for tax purposes. If you earn more than those limits, an IRA may not be an option for you.

Health Savings Account

Health savings accounts, or HSAs, were designed to be used for medical expenses, but they can also function as a high-powered retirement account.

In fact, health savings accounts are the only investment accounts that offer a triple tax break:

  1. Your contributions are deductible.
  2. Your money grows tax-free inside the account.
  3. You can withdraw the money tax-free for qualified medical expenses.

On top of that, many HSAs allow you to invest the money, your balance rolls over year to year, and as long as you keep good records, you can actually reimburse yourself down the line for medical expenses that occurred years ago.

Put all that together with the fact that you will almost certainly have medical expenses in retirement, and HSAs are one of the most powerful retirement tools available to you.

The catch is that you have to be participating in a qualifying high-deductible health plan, which generally means a minimum annual deductible of $1,300 for individual coverage and $2,600 for family coverage.

If you’re eligible though, you can contribute up to $3,400 if you are the only individual covered by such a plan, or up to $6,750 if you have family coverage.

Backdoor Roth IRA

If you’re not eligible to contribute to an IRA directly, you might want to consider something called a Backdoor Roth IRA.

The Backdoor Roth IRA takes advantage of two rules that, when combined, can allow you to contribute to a Roth IRA even if you make too much for a regular contribution:

  1. You are always allowed to make non-deductible traditional IRA contributions, up to the annual $5,500 limit, no matter how much you make.
  2. You are also allowed to convert money from a traditional IRA to a Roth IRA at any time, no matter how much you make.

When you put those together, high-earners could make non-deductible contributions to a traditional IRA, and shortly after convert that money to a Roth IRA. From that point forward the money will grow completely tax-free.

There are some potential pitfalls, and you can review all the details here. But if you are otherwise ineligible to make IRA contributions, this is a good option to have in your back pocket.

Taxable Investment Account

While dedicated retirement accounts offer the biggest tax breaks, there are plenty of tax-efficient ways to invest within a regular taxable investment account as well.

These accounts can be especially helpful for nearer term goals, since your money isn’t locked away until retirement age, or for money you’d like to invest after maxing out your dedicated retirement accounts.

How to Decide Between Additional 401(K) Contributions and Other Retirement Accounts

With those options in hand, how do you decide whether to make additional 401(k) contributions, beyond the amount needed to max out the employer match, or to contribute that money to other accounts?

There are a few big factors to consider:

  • Eligibility – If you’re not eligible to contribute to an IRA or HSA, a 401(k) might be your best option by default.
  • Costs – Cost is the single best predictor of future investment returns, with lower cost investments leading to higher returns. You’ll want to prioritize accounts that allow you to minimize the fees you pay.
  • Investment options – You should prioritize accounts that allow you to implement your preferred asset allocation, again with good, low-cost funds.
  • Convenience – All else being equal, having fewer accounts spread across fewer companies will make your life easier.

With those factors in mind, here’s a reasonable guide for making the decision:

  1. Max out your employer match before contributing to other accounts.
  2. If your 401(k) offers low fees and investments that fit your desired portfolio, you can keep things simple by prioritizing additional contributions there first. This allows you to work with one account, at least for a little while, instead of several.
  3. If your 401(k) is high-cost, or if you’ve already maxed out your 401(k), a health savings account may be the next best place to look. If you can pay for your medical expenses with other money, allowing this account to stay invested and grow for the long term, that triple tax break is hard to beat.
  4. An IRA is likely your next best option. You can review this guide for a full breakdown of the traditional versus Roth debate.
  5. If you’re not eligible for a direct IRA contribution, you should consider a Backdoor Roth IRA.
  6. If you maxed out your other retirement accounts because your 401(k) is high-cost, now is probably the time to go back. While there are some circumstances in which incredibly high fees might make a taxable investment account a better deal, in most cases the tax breaks offered by a 401(k) will outweigh any difference in cost.
  7. Once those retirement accounts are maxed out, you can invest additional money in a regular taxable investment account.

The Bottom Line: Maximize Your 401(k)

A 401(k) is a powerful tool if you know how to use it. The tax breaks make it easier to save more and earn more than in a regular investment account, and the potential for an employer match is unlike any opportunity offered by any other retirement account.

The key is in understanding your 401(k)’s specific opportunities and how to take maximum advantage of them. If you can do that, you may find yourself a lot closer to financial independence than you thought.

Advertiser Disclosure: The card offers that appear on this site are from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all card companies or all card offers available in the marketplace.

Matt Becker
Matt Becker |

Matt Becker is a writer at MagnifyMoney. You can email Matt here

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