Let’s take a quick look at 401(k) loans. Some people are not aware of this, but if you have a 401(k) retirement account you can borrow money from yourself. You can take out a loan from your own retirement account for pretty much any reason. The rules about how much you can borrow and how soon it needs to be paid back are a little different for mortgages on your primary residence, but let’s stick with the more usual case for now.
You can borrow up to half of the value of your 401(k), or a maximum of $50,000. Interest rates are fixed and generally pretty low, and the loan term cannot exceed five years. The loan must be repaid by payroll deduction, and this leads to the first potential “gotcha”… if you leave your job or get laid off, the entire loan balance is due and payable within 90 days. If you can’t pay it off in 90 days, it’s treated as an early withdrawal from your 401(k) and there are some pretty unpleasant tax implications — not to mention the money doesn’t go back into your retirement account as it should. So, in general you really only want to consider a 401(k) loan if your employment situation is stable, and/or if you have the cash reserve or other assets (like a stock brokerage account) you could liquidate to pay the loan off within a couple of months if you have to. If you decide to change jobs while you have an outstanding 401(k) loan, you’ll need to figure out how to take care of that because loan repayments have to be deducted from your current employer’s payroll.
So, the convention wisdom, the advice you will usually hear, is that 401(k) loans are a bad, bad idea. All kinds of analysis and predictions of financial doom are easy to find, and all seem to make some basic assumptions. The most consistent assumptions seem to be that you’re desperate for the money, and that while repaying the loan you’re not going to be contributing to your retirement plan. That of course means you lose any employer matching funds. A lot of the advice I’ve read also assumes you’re making some kind of mad return on your 401(k) investments — something which just has not held true lately, though the days of 10%-plus returns may return before long. If you don’t meet those assumptions, though, you can make it into a pretty good deal.
Let’s assume you have a couple of car loans, which you’re paying on schedule. Let’s also assume that you have about $40K between the two, and are paying around 5.99% as seems to be about average now. Your two car payments add up to a little over $900 per month, and all the interest is of course going to your lender. Now let’s assume you could:
- Drop $300 a month off your payments
- Get a lower interest rate
- Get the car loan balances off your credit report
- Show both loans as paid in full
- Have clear title to your vehicles
- Give yourself all of the interest on the loans from now on
Sounds pretty good, right? Enter the 401(k) loan. This can work out very well, assuming you don’t stop contributing to your retirement plan while you’re paying off the loan. Keep contributing what you have been; certainly enough to at least get your employer’s full matching contributions. All of the monthly principle and interest on your loan goes directly back into your 401(k). The interest rate is usually lower that what you’re already paying on your car loans — and what do you care what the interest rate is, anyway? In fact, a higher interest rate can work in your favor! It’s all going into your own retirement account.
If your 401(k) investments are doing significantly better than the interest rate on your loan then, yes, you’re losing a little bit of investment income that you might otherwise have. It may or may not equal or exceed the money you’re paying your lender in the form of interest. Your individual rate of return can tell you that; if it’s more than the rate you’re paying on your car loan and what you’d pay on the 401(k) loan, you may want to think about whether the other aspects make it worthwhile or not. And, yes, there is a little risk of things going south if you lose your job and can’t pay off the full amount of the loan. Even that’s not a crushing blow, though — you still have unencumbered title to your vehicle(s), and there is no adverse credit report information, no collection agency. You simply pay the tax penalty on an early withdrawal from your 401(k).
So the next time you’re looking at financing a car or other major purchase, you might want to do a little research. See if a 401(k) loan is a good idea for you or not. Don’t blindly take anyone’s advice — mine included — without doing your own research and running the numbers.