3 money strategies that can backfire

Borrowing from your 401(k) rather than a bank

Here's the rationale in a nutshell:

"The stock market sucks. My money's not doing anything for me except disappearing. I'd get a better return borrowing from my 401(k) and paying myself the interest."

If you're singing a similar tune, here's what you need to know:

The biggest risk is that you'll lose your job. If that happens and you can't pay the remaining balance back quickly, the unpaid loan will become a withdrawal. And that's really, really bad. You'll owe income taxes and penalties equal to as much as half of the loan.

Even worse, you'll lose all the future tax-deferred returns you could have earned on that money. Figure every $10,000 you withdraw prematurely from a retirement fund will cost you $100,000 in lost retirement income, assuming 8% average annual returns over 30 years (over that long a period, 8% returns are a reasonable assumption).

You don't know when the market will bounce back. The money you've borrowed will earn a steady return, usually the prime rate plus 1 or 2 percentage points. But that return is coming out of your own pocket, since your funds are no longer earning returns for you in the stock market.

Furthermore, those missing funds won't be able to participate in any market rally. You may find it hard to believe when stocks are falling, but sometimes the market does go up, and you'll be missing out on the money you've borrowed.

Another big risk: contribution shrink. You may have to cut back on your 401(k) contributions in order to afford the loan payments. Some companies even block you from contributing while you have a loan. (Bad companies! Bad!) Either way, smaller contributions mean a smaller future nest egg.

Perhaps you're overspending. When we want something, we tend to get creative about justifying the purchase.Yes, theoretically it may be better to pay yourself 6% interest on a loan to fund your vacation, rather than paying 13% on a credit card. But the reality is that you shouldn't borrow to fund a vacation, a flat-screen television or any other luxury. If you can't pay cash for such spending, you can't afford it.

Bottom line: Think long and hard before you touch your retirement funds for any reason other than retirement. Don't borrow from your 401(k) if your employer won't let you make contributions while you have an outstanding loan. (See "Workers step up raids on 401(k)s.")

Using your house to refinance student loans

Maybe you consolidated when rates were higher and have lived to regret it. Or maybe you've got a boatload of variable-rate private loans. Either way, it can be tempting to replace the debt with cheaper home-equity borrowing.

Every few months, I hear from a reader who wants to try this. A few years ago, the plan was usually to do a cash-out refinance and use the extra money to pay off the student loans. Today, with cash-outs so tough to do, the typical solution is a home-equity loan or line of credit.

This seems especially tempting to higher-income folks who make too much money to deduct their student loan interest but who can still deduct mortgage and home-equity debt.

Here's what they usually miss:

You're giving up flexibility. If you run into a financial bind, you can typically negotiate with your student lender to get your payments lowered or even suspended for a while. (Federal student loans offer the most flexibility, but even private student loans often have payment and forbearance options.) As millions of Americans are finding to their chagrin, getting a mortgage lender to modify a loan can be tough, if not impossible.

You're putting your home at risk. If things get really bad and you can't pay a student loan, you'll have to deal with collection calls, the seizure of your tax refund and possible wage garnishments. That's tough, but if you can't pay home debt, you can lose your home. There's a big difference between being giving up your tax refund and sleeping in your car.

You may need that home equity in an emergency. If you borrow it, that money isn't available for other uses, such as supplementing your emergency fund if you get laid off or paying for medical care should you lose your insurance. If you have lots of equity, that might not worry you, since it may seem like you'll still have plenty left over. But keep in mind that lenders are shutting off home-equity lines left and right. If housing prices continue to decline, they could get even more aggressive about trimming what you can borrow.

Bottom line: Consider trading student loan debt for home debt only if your job is rock-solid, you'll still have plenty of equity left, you can afford the payments and your finances are otherwise in good shape.

Liz Pulliam Weston's latest book, "Easy Money: How to Simplify Your Finances and Get What You Want Out of Life," is now available. Columns by Weston, the Web's most-read personal-finance writer and winner of the 2007 Clarion Award for online journalism, appear every Monday and Thursday, exclusively on MSN Money. She also answers reader questions on the Your Money message board.

Published July 31, 2008

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