Consumers have plenty to worry about during a challenging economy, and making a wrong move in personal finances could make a bad situation worse. Obtaining cash through credit cards, retirement plans and home equity could end up being a costly quick fix. And complacency over personal investments and looming college costs could lead to missed opportunities for keeping hard-earned dollars.
Here's how to avoid some common pitfalls during an economic downturn.
1. Living la vida Visa. One of the most common responses to a financial crisis, such as a job loss, is to continue spending with credit cards, says Gail Cunningham, spokeswoman for the National Foundation for Credit Counseling.
"We're great spenders but lousy savers," Cunningham says. "We're a hopeful lot of people. We keep thinking that our ship is going to come in."
But the reality is that it typically takes a job seeker one month to replace $10,000 of lost income, she says. So a prospective employee should expect it will take five months to replace a $50,000-a-year job.
1. Living la vida Visa. One of the most common responses to a financial crisis, such as a job loss, is to continue spending with credit cards, says Gail Cunningham, spokeswoman for the National Foundation for Credit Counseling.
"We're great spenders but lousy savers," Cunningham says. "We're a hopeful lot of people. We keep thinking that our ship is going to come in."
But the reality is that it typically takes a job seeker one month to replace $10,000 of lost income, she says. So a prospective employee should expect it will take five months to replace a $50,000-a-year job.
Rather than continue a lifestyle financed by credit cards -- and compounding debt in the process -- consumers should "circle the wagons" by figuring out where they spend their money, Cunningham says.
Just as calorie-counters keep logs of every meal and snack, consumers should keep a meticulous watch on incidental purchases such as meals in restaurants, nights out at the movies, and, of course, gourmet cups of coffee. Think of it as an expense report to yourself.
"Nobody likes to do it, but you can do anything for 30 days," she says. "Tracking your spending is one of the most basic elements of financial stability."
Once consumers have a handle on spending, do they have go cold turkey on all of the good life's trappings? Not necessarily.
Cunningham suggests that cutting back on some expenses is better than cutting them out.
Comb through cable bills, cell phone plans, and other services for lower-cost alternatives. Folks who haven't watched HBO since the finale of "The Sopranos" or never started a conversation with a text message may rein a few bucks per month by dumping these options.
Just as calorie-counters keep logs of every meal and snack, consumers should keep a meticulous watch on incidental purchases such as meals in restaurants, nights out at the movies, and, of course, gourmet cups of coffee. Think of it as an expense report to yourself.
"Nobody likes to do it, but you can do anything for 30 days," she says. "Tracking your spending is one of the most basic elements of financial stability."
Once consumers have a handle on spending, do they have go cold turkey on all of the good life's trappings? Not necessarily.
Cunningham suggests that cutting back on some expenses is better than cutting them out.
Comb through cable bills, cell phone plans, and other services for lower-cost alternatives. Folks who haven't watched HBO since the finale of "The Sopranos" or never started a conversation with a text message may rein a few bucks per month by dumping these options.
2. Invading your nest egg. Economic downturns have a way of drying up consumers' liquidity. Meanwhile, creditors only get thirstier. But as tapped-out consumers have fewer options to get cash, they may be tempted to withdraw from an IRA or borrow from a 401(k) plan.
Taking cash out of a traditional IRA can lead to a double-whammy of a 10-percent penalty and taxes of at least 25 percent if the individual is younger than 59½, says Ira Marks, a Certified Financial Planner based in Lawrenceville, N.J.
For example, a couple with a combined yearly income of $100,000 who withdrew $25,000 would pay a $2,500 penalty, plus a tax of $6,250 for a total of $8,750, Marks says. State taxes would also be added.
Taxes and penalties would be more for a couple who earns more money. A couple who makes $200,000 annually would pay $10,833 for the same $25,000 withdrawal, Marks says.
There are exceptions, such as if the withdrawal is made to pay for medical expenses, he adds.
Another caveat to note: If the money is replaced within 60 days, there will be no taxes or penalties -- good to know if you need a quick infusion of cash for a college tuition payment before a commission check comes in, for example.
"But most people don't become aware of that until they are working with their tax preparers the following year," Marks says. By that time, the 60-day window to avoid losing money to taxes and the penalty has closed.
For a Roth IRA, a person younger than 59½ who withdraws the earnings within the first five years of opening the account would pay the 10-percent penalty and taxes. There is no penalty or tax assessed when direct contributions (not including rollover contributions) to a Roth IRA are withdrawn.
Consumers who may be leaving their jobs soon -- either voluntarily or not -- may want to think twice before borrowing against a 401(k) plan. Once an employee leaves a company, the loan turns into a taxable withdrawal, triggering the federal government's 10-percent penalty, Marks says.
3. Paying for college without applying for aid. An Aug. 20 Sallie Mae/Gallup survey found that one-fourth of families with children in college did not send in the Free Application for Federal Student Aid, or FAFSA, for the 2007-2008 school year.
"It's probably the simplest thing you can do to make sure you're not missing out on free money or low cost money," says Patricia Nash Christel, a Sallie Mae spokeswoman
For example, a couple with a combined yearly income of $100,000 who withdrew $25,000 would pay a $2,500 penalty, plus a tax of $6,250 for a total of $8,750, Marks says. State taxes would also be added.
Taxes and penalties would be more for a couple who earns more money. A couple who makes $200,000 annually would pay $10,833 for the same $25,000 withdrawal, Marks says.
There are exceptions, such as if the withdrawal is made to pay for medical expenses, he adds.
Another caveat to note: If the money is replaced within 60 days, there will be no taxes or penalties -- good to know if you need a quick infusion of cash for a college tuition payment before a commission check comes in, for example.
"But most people don't become aware of that until they are working with their tax preparers the following year," Marks says. By that time, the 60-day window to avoid losing money to taxes and the penalty has closed.
For a Roth IRA, a person younger than 59½ who withdraws the earnings within the first five years of opening the account would pay the 10-percent penalty and taxes. There is no penalty or tax assessed when direct contributions (not including rollover contributions) to a Roth IRA are withdrawn.
Consumers who may be leaving their jobs soon -- either voluntarily or not -- may want to think twice before borrowing against a 401(k) plan. Once an employee leaves a company, the loan turns into a taxable withdrawal, triggering the federal government's 10-percent penalty, Marks says.
3. Paying for college without applying for aid. An Aug. 20 Sallie Mae/Gallup survey found that one-fourth of families with children in college did not send in the Free Application for Federal Student Aid, or FAFSA, for the 2007-2008 school year.
"It's probably the simplest thing you can do to make sure you're not missing out on free money or low cost money," says Patricia Nash Christel, a Sallie Mae spokeswoman
The federal government uses the information on the form to determine an applicant's eligibility for Pell grants, subsidized Stafford loans and other financial aid, she says. Private organizations often use the information when awarding scholarships.
The survey also found that only 9 percent of the 1,404 families questioned reported using a 529 savings plan, a state-sponsored investment account that accumulates tax-free earnings. Those with a 529 plan used up to $8,000 toward last year's education costs, which on the average were $14,628, according to the survey.
Meanwhile, 38 percent of the families surveyed paid for tuition, room and board, and all other college-related expenses with personal income.
Christel says that parents are so committed to sending children to college, seeing it as an investment in their family's future, that they often give little thought to education costs and what happens after graduation, such as paying back loans and what the student's income will be after school ends.
Meanwhile, 38 percent of the families surveyed paid for tuition, room and board, and all other college-related expenses with personal income.
Christel says that parents are so committed to sending children to college, seeing it as an investment in their family's future, that they often give little thought to education costs and what happens after graduation, such as paying back loans and what the student's income will be after school ends.
4. Investing inertiaLong-term investing used to be easier: Pop the cash into the mutual funds and annuities and watch the returns rise like bread in an oven. But even consumers with a little dough are prone to avoiding the complex implications that the volatile stock market may have for their investments.
Lyle Benson, who owns a financial services firm in Baltimore, says that investors can get lulled into complacency when they should be reviewing their asset allocations to make sure they are keeping up with earnings targets.
While a portfolio should always have some amount of stocks to ensure growth in the long run, keeping too many stocks during a down market can be costly, Benson says. Sheltering cash in treasury bills or bonds can help a portfolio hold up in a bear market.
Older investors are often attracted to the low risk of CDs, especially since some analysts are projecting rates will increase in the coming months.
Benson advises investors to avoid locking in large amounts cash for periods longer than a year. An investor hasn't gained anything if living expenses increase 4 percent or 5 percent, and the deposit is locked in at 3.5 percent, he says. Depositing in new CDs every six months to a year will allow for rate changes.
"The idea is to have money coming due each year," Benson says.
Lyle Benson, who owns a financial services firm in Baltimore, says that investors can get lulled into complacency when they should be reviewing their asset allocations to make sure they are keeping up with earnings targets.
While a portfolio should always have some amount of stocks to ensure growth in the long run, keeping too many stocks during a down market can be costly, Benson says. Sheltering cash in treasury bills or bonds can help a portfolio hold up in a bear market.
Older investors are often attracted to the low risk of CDs, especially since some analysts are projecting rates will increase in the coming months.
Benson advises investors to avoid locking in large amounts cash for periods longer than a year. An investor hasn't gained anything if living expenses increase 4 percent or 5 percent, and the deposit is locked in at 3.5 percent, he says. Depositing in new CDs every six months to a year will allow for rate changes.
"The idea is to have money coming due each year," Benson says.
Tom Kelly, spokesman for JP Morgan Chase & Co., says that previously the bank had been originating loans at 95 percent to 100 percent of a home's value. But following the subprime mortgage meltdown, that threshold has dropped to 80 percent in most housing markets, Kelly says.
"So on a $200,000 home, the most you can expect is $160,000," he says. "Our standards are probably in line with other lenders."
Marks says he hopes people's spending habits would change as a result of the limits on home equity loans.
But in some cases, tapping into a home's value may be the only option to get cash.
David Certner, AARP's legislative counsel, says he expects people over the age of 62 to become more interested in reverse mortgages.
Living expenses will continue to increase, and seniors on fixed incomes and no assets other than their homes will need to establish cash flow.
A reverse mortgage allows a homeowner to receive nontaxable payments based on the value of a home with a mortgage that has been paid. It is sometimes described as a house paying the homeowner back.
"So on a $200,000 home, the most you can expect is $160,000," he says. "Our standards are probably in line with other lenders."
Marks says he hopes people's spending habits would change as a result of the limits on home equity loans.
But in some cases, tapping into a home's value may be the only option to get cash.
David Certner, AARP's legislative counsel, says he expects people over the age of 62 to become more interested in reverse mortgages.
Living expenses will continue to increase, and seniors on fixed incomes and no assets other than their homes will need to establish cash flow.
A reverse mortgage allows a homeowner to receive nontaxable payments based on the value of a home with a mortgage that has been paid. It is sometimes described as a house paying the homeowner back.
Certner says the U.S. Housing and Economic Recovery Act of 2008 makes reverse mortgages more attractive by:
Raising the amount of equity homeowners can borrow against.
Capping origination fees.
Protecting seniors against inappropriate practices by lenders.
However, a reverse mortgage should remain a "last resort" for seniors because it is still an expensive proposition, he says.
The new housing law allows a maximum of $6,000 for an origination fee. The fee is based on the law's new scale of 2 percent for the first $200,000 of home value, and 1 percent per $100,000 of remaining home value, Certner says. Previously, homeowners were charged 2 percent of the home's value.
A reverse mortgage could use up the entire value of a home, and the homeowner is responsible for property taxes and home maintenance, which is why Certner suggests considering all options before using a reverse mortgage.
"It may be more appropriate to sell your home and move," he says.
Previously, seniors had fallen prey to being sold annuities, long-term care insurance and other inappropriate products by the same agents who sold the reverse mortgages. The new housing law prohibits this practice, but Certner says seniors should remain on their guard.
"Those products are rarely in your interest," he says.
Raising the amount of equity homeowners can borrow against.
Capping origination fees.
Protecting seniors against inappropriate practices by lenders.
However, a reverse mortgage should remain a "last resort" for seniors because it is still an expensive proposition, he says.
The new housing law allows a maximum of $6,000 for an origination fee. The fee is based on the law's new scale of 2 percent for the first $200,000 of home value, and 1 percent per $100,000 of remaining home value, Certner says. Previously, homeowners were charged 2 percent of the home's value.
A reverse mortgage could use up the entire value of a home, and the homeowner is responsible for property taxes and home maintenance, which is why Certner suggests considering all options before using a reverse mortgage.
"It may be more appropriate to sell your home and move," he says.
Previously, seniors had fallen prey to being sold annuities, long-term care insurance and other inappropriate products by the same agents who sold the reverse mortgages. The new housing law prohibits this practice, but Certner says seniors should remain on their guard.
"Those products are rarely in your interest," he says.
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