Be Careful with Home Equity and 401k Credit Cards

Here's a guest post from Emily at Credit Cards Blog.

Credit cards mean different things to different people. Some see them as a way to get by when unexpected expenses arise. Some see them as a necessary evil that enslaves them to crippling debt. Others see them as an investment opportunity and funnel their 0 percent APR credit lines into a high-yield savings account to make money.

It should be noted, however, that the advent of the home equity credit card and 401(k) debit card should frighten even the hardiest plastic user. Misuse of these products can result not just in debt, but in the loss of your home and future financial security.

HELOC credit cards

The Federal Reserve explains a home equity line of credit, or HELOC,  as "a form of revolving credit in which your home serves as collateral." A HELOC functions like a credit card and is slightly different from a home equity loan, which functions more like a mortgage. A home equity loan is one lump sum used for one major expense. A HELOC allows you to draw multiple times as needed for a certain period of time, such as 10 years, and it can be accessed by electronic transfer, check or a home equity credit card. You pay back only what you use in addition to interest, which is set at a variable rate. This means your rate will fluctuate, for better or worse. Interest paid is often tax deductible, which can reduce borrowing costs.

Over the past few years, banks have begun issuing HELOCs in the form of credit cards to consumers. Harris, a financial service organization, recently launched a MasterCard that allows customers to access their home equity line of credit through the card. The card can be used like a credit card or as a debit card for ATM withdrawals. Chase also has one, called the Chase Equiline Platinum Visa.

The Federal Reserve says most people use HELOCs for major expenses such as education, home improvements or medical bills rather than day-to-day expenses. But by utilizing this line of credit with a credit card, it is easier to spend frivolously on mundane purchases. Your home is probably your largest asset, and it is something you may not want to put at risk by living above your means. If you fail to repay the loan, your house will be foreclosed.  As if we haven't seen enough of that lately.

CNN Money says HELOCs are ideal for those who have already paid off their first mortgages and want quick access to cash in case of emergency. Remember: While your home equity is more easily accessible in the form of plastic, it's one debt you can't afford to default on.

401(k) debit cards

For those who don't know, 401(k)s are employer-sponsored retirement plans. A set portion of the employee's income is paid directly to the investment account, and taxes are deferred on the money and earnings until funds are withdrawn. If you try to take the money out before age 59 1/2, you are subjected to harsh tax penalties. You can take a loan out from your 401(k), but the loan must be repaid within five years if you are still with the company, and interest is charged. If you take a loan out and then leave the company, you must pay the 401(k) loan back within 60 days, or you are charged extra fees and taxes.

Now some companies offer employees a debit card, called ReservePlus, which allows loans to be taken from their 401(k) accounts. Once employees are approved for a loan, they receive the debit card, with which they can take out as much as they want from the loan. ReservePlus functions as an ATM card that can be used to withdraw cash or buy goods and services. It has been around for a few years, but its popularity has been growing.

According to an article on The Street, the loan doesn't begin until money is actually taken from the account and usually lasts around five years. Employees are billed directly, and pay back much as they would a credit card. Some employers offer revolving loans, allowing employees to remove and return money as needed.

Using these cards should be a last resort. The extra taxes and fees imposed upon 401(k) loans add up. The Washington Times wrote an article about the dangers of 401(k) cards and quotes a financial planner, Stuart Ritter from T. Rowe Price, who says these cards are a bad investment. Ritter says for every $10 you take out in loans, you only have about $6 of it to spend after expenses, so you're essentially losing a third of your money. "You're also giving up money to spend in retirement, so you are by definition lowering your lifestyle in retirement," Ritter tells the Times.

One perk of the card is that employees can pay off the loan in a time frame of several years, even if they leave the company. That is not an option with a regular 401(k) loan, so that may be helpful for some. One major downfall of the debit card is that its interest rate is higher than that of traditional loans. According to The Street article, ReservePlus loans typically have interest rates 2.9 percent higher than the prime rate.

While a major financial crunch may cause you to fall back on your retirement savings, remind yourself how long you've been stashing that money aside so you can enjoy old age comfortably. This money should be left alone if possible. If taking a loan from your 401(k) is your only option for an emergency situation, it may be manageable, but pay it back as soon and as fast as you can. Otherwise, I'd suggest using a 0 percent APR credit card to avoid the tax penalties, high interest rate and additional fees.

Think first

Most Americans have abandoned the saving mentality and prefer to make purchases on credit, which can be dangerous. Before you borrow against your home or drain your retirement fund, ask yourself if it's really worth it. Determine how vital the purchase really is, because these loans are complicated and can have dire consequences if mismanaged. Ask yourself if it is possible to spend a few months saving up instead, or if there is a low-interest credit card that could better do the job. Using the HELOC or 401(k) cards may work well for some financial crises, but they are not ideal for people who just want another way to live above their means. If you are highly concerned about your finances, before taking such a drastic step, consider meeting with a fee-only financial planner. He or she can help determine the wisest path for you.

Comments

[Veteran Military Wife at Life Lessons of a Military Wife]

Is this the ugly way of things to come? Have we learned nothing at all the last few years? So now people will raid what little retirements they have and if they have anything left in their homes, they will take that too...and "thank-you" US companies for making it now so much easier than before...when will people start living within their means? I guess this means the rest of us will have to bail them out in 20 years...I'm wondering what it's going to take to change our consumer and "want it now" mentality..that's what's at the root of all this anyway.

[CreditCardDude]

Gosh, these newfangled cards that tap into your home equity or 401(k) account sound like a great and responsible new product from card industry. Swipe away your home equity! Swipe away your retirement! Sounds great! The only away it could be better: Install these machines in Las Vegas by attaching them to slot machines! What fun!

[Miranda]

It's getting WAY too easy to just "charge it" and "forget about it." And now, instead of miring the present, it looks as though we can mire the future as well. Hmmm...