401(k) loans: Great Option or Bad Idea?

After hearing a co-worker talk about taking a 401(k) loan to help with the downpayment on his new house, I decided to ask the HR Department about it. Here are the rules for my company, yours may be slightly different.

You can borrow the lesser of 50% of your vested balance, or $50,000. So with my current financial status, that would be approximately $6,000. The interest rate charged is WSJ Prime + 1% at the initiation of your loan (Currently 5.5+1 = 6.5%). But the interest is paid directly back into your account. You can repay it over 20 years if the loan if for your house, and 5 years otherwise.

At first glance, this seems like a great option. You get to borrow you own money so that you can make your downpayment larger, avoid paying Private Mortage Insurance (PMI), and since you’re loaning yourself the money, the interest goes back to yourself! I didn’t know you could stretch it out for so long – 20 years?!

If you look closer, however, the situation is a significantly more complicated. The key is that you need to estimate the amount of money that you would be earning if you didn’t borrow that money. I mean, that’s why it’s there right? To compound tax-free for retirement? What you save in PMI or mortgage interest must be balanced out by the amount that you would be losing in retirement.

In addition, you will be taking out pre-tax money, but paying the interest back with post-tax money. For example, if your monthly interest payment is $250 and you’re in the 25% tax bracket. You’ll have to make $333 pre-tax to make $250 post-tax. Then, when you retire and take the money out once more, you pay taxes yet again. Doh.

This doesn’t mean you shouldn’t definitely do it. It just means you have to carefully weigh the consequences. This MSN Money article shares more information about the pros and cons. From that article, in 1998, 9% of the nation’s 401(k) participants took loans against their 401(k) plans. An plan experts say that overall, 20% of 401(k) participants are paying back loans. Be sure you aren’t “mortgaging” your future for that house. (Ok, bad joke, it’s early.)

Update: Here is another article about 401(k) loans and includes some sample calculations. Also, if you have a 401(k) loan yourself I’d love to hear your thoughts and experiences!

Comments

  1. “In addition, you will be taking out pre-tax money, but paying it back plus interest with post-tax money. For example, if your monthly payment is $250 and you’re in the 25% tax bracket. You’ll have to make $333 pre-tax to make $250 post-tax. Then, when you retire and take the money out once more, you pay taxes yet again. Doh.”

    I have never understood this arguement, Suze Oreman uses it as well, if you are taking out the money tax free from the loan why are you paying double tax??? If you didn’t take the loan out you would still have to pay tax on the money you get in your paycheck.

  2. Now I’m an engineer not an accountant, but here’s my take:

    Ok, let’s say you had just $10,000 in your 401k, and your tax bracket is 25%. It was never taxed, so it “could” have been $7500 post-tax. You decide to take out a loan on the $10,000, let’s ignore interest. You are getting $2500 “free” for now.

    In order to pay back the $10,000, you would need to earn $13,300 pre-tax. You now pay $3,300 tax to repay your $10,000. Even ignoring interest, you are (3,300-2,500=) $800 behind. Then in retirement it’s all taxed again. It’s not that your paying twice the tax, you are paying (some)taxes twice. Or simply more tax.

    $800 out of $10k is already an 8% hit. Now, if you account for interest, it gets worse. It’s all going to be post-tax money to your 401k, that was never initially taken out tax-free.

    Did that make any sense? I’m sure someone will correct me if I’m wrong.

  3. The calculation begs some questions. Assuming you will save $13,300 before tax and $10,000 after tax anyway. No matter you took the $10k loan or not, you still need to pay $3,300 on tax, so you cannot argue you will be $800 worse off.

    Your double-taxation argument only holds for the interest-part of the repayment. Take a look at the details here for the real cost of 401(k) loan:

    http://www.pfblog.com/archives/000295.shtml

  4. I also do not understand the reasons given by the “experts” for not borrowing from your 401k.
    Whether you borrow the money from your 401k or from a lending institution the money is tax free and is repaid with after-tax dollars.
    The downside to borrowing from your 401k,to me, is if you cannot repay the money and have to pay the tax and penalties and if the investments outperform the interest you would pay to yourself.

  5. mm – you’re right, it is only the interest that is double taxed. If you use your argument, then the interest is only 6.5*25% = 1.5% in my case. So then basically if you really need a loan for something, like credit cards or a car or even a house, then if you can’t beat 1.5% then you should borrow from your 401k? interesting.

    bill – don’t know, but i’m sure part of is probably exactly what you pointt out, the fact that many people don’t end up paying it back after using it to cover debts, and then running them back up again.

  6. I have been wondering about this too. So I did what I do when I want to work through something — I put in some numbers in and plug through it.

    Here’s my scenario.
    * 100K in 401K, can borrow 50K at 6.5%
    * Person is buying a 500K house. Has $50K for down payment, needs another 50K to avoid PMI (more on that later).

    So what happens to the 401K if you borrow?

    Let’s assume that you get 8% on the 401K, and we will ignore any future contributions (because they would be the same in either scenario).

    If you don’t borrow, at the end of 20 years you would have $466,096. (this is at 8% per year)

    If you do borrow 50K, then you get to make yearly payments of $4,538 for 20 years, back into the 401K.

    In this scenario, the 401K only has $440,707 in it at the end of 20 years. (as compared to 466,096 if you don’t take the loan)

    The reason is that part of your 401K is only making 6.5% if you borrow as compared to 8% if you leave it in.

    Now of course if your 401K does not average above 6.5% for this 20 yr period, then you would be better off (401K speaking) to take the loan.

    But in general — there is two take aways.

    1) You don’t have to raid your 401K to avoid PMI. Just get a home equity loan at the same time as your first mortgage (called 80/10/10 — 80% first, 10%cash down, 10% equity loan) Even if you have to pay 7.5% or 8% on the HELO it’s still better than raiding your 401K — a) because it is tax deductible and b) because you don’t vacuum $25K out of your 401k in the process.

    2) Its best to have the mindset that your 401K is not a cash machine. Use other resources first.

    Now I just did something similar to the above, had 10% down that I had saved, borrowed 10% from my Dad, and then got an 80% first mortgage.

    I get a low interest 2nd loan, my Dad gets higher interest than he would at Emigrant Direct, and his money is almost guaranteed (in kind of a weird way) — Even if I default (which hopefully I won’t), he can get “his” money back by subtracting it from my future inheritance.

    Thoughts??

  7. Still try to figure out what is the real catch to take 401k loan. After asked many people including some experts, I am still not sure about that. I agree most of the posts here, but few account that the loan is pretax money (you spend money without paying tax!).

    It seems to me that the only catch is that you pay 2x tax on the interest and opportunity value of the loan. However, if you are lucky, say you take the loan at peak of the market it could be pan out pretty well for you.

    Here is my calculation: say, you take 10k loan out of you 401k. You did not use it but put it in a saving account (X) instead (for calculation purpose only), and then you use the money (pretax right?) to pay for the loan. At the end of the loan (say after 5 years), you pay off the loan principle, 10k, with the pretax money from you saving account X and interests (after tax). You keep all the interest to yourself plus the interest generated in the saving account X. Does this make sense?

    Ken

  8. This is when we are talking about taking out money to buy a house, but what if the money is to pay off $3000.00 in credit card debt like I have. The 6.5 percent interest looks really good compared to the 18 percent (or more in some cases) that the credit card company would get and I don’t have to cut a check to do it, the company automatically takes it out of my check.

    Another point that should be considered is that you are talking about the money that would end up back in your 401k. Aren’t we forgetting that, if you don’t borrow from your 401k you will have to borrow from a private lender. So the money that you would be paying will all be going out and none of it will come back in.

    In other words, and it’s too late to do the math for me, if you borrowed the 50K to buy the house all of the payments would be going to the lender, so the total interest you would pay would be 35971.00 (This is from the Bankrate loan calculator and based on a 6 percent loan) bringing the total out of pocket for the loan to be $85,971.00!

    This would bean that your total worth would be $466,096.00-$85,971=$380,125.00. Now your going to say that you will get a tax deduction for the interest, but do you trust that that tax deduction will always be there?

    I’m nowere near as smart as most of you people, but I just wanted to make that point. Please let me know if I’m wrong.

  9. OK. Let’s say 3 years ago, your 401K was valued at $300K but due to the economy it’s current value is $100K and still dropping… let’s say you have $30K of debt with an average interest rate of 12%.

    Considering that paying off any high interest debt is your first best investment, why would you not take that $30K out of the 401K and payoff the debt and repay the 401K at say 4.5%? First off, the main detractor to pulling money out of the 401K is the loss of the compounding interest on the amount removed. If the 401K however is losing value, then is it not better to reduce the amount subjected to the losses? For that matter, take the max amount out (50% or $50K in this example), payoff any debts and put the rest into a savings account.

    I see three wins here by taking the loan. The high interest debt is gone, you’ve reduced the amount in your 401K subject to losses and you’re paying yourself back a higher interest rate than the money would have gained (lost) had you left it alone?

    Granted, I’m no economist but it makes sense to do this. In fact, it should have been done when the value of the 401K initially started falling.

    Am I incorrect in my assumptions here? Given the above scenario, where does the tax issue have an impact (and to what degree) if the loan is paid back over a 5 year term?

  10. the reasons these “experts” advise us not to take $ out of our 401k is because “they” can invest it so wisely! they are in the business of making $ off off of our money. If we take our money away from them, they wont be making any $ off our money. If this was your business, you would have to be crazy, IF you didnt say OUR idea was bad.

  11. Why do people keep trotting out the line that you have to pay it back with taxed money, and then get taxed again when you are 65?

    It doesnt matter, you didnt get taxed on that money in the first place.
    So there is more there than would normally be.

    If you think about it and pretend you do not take the money and buy something stupid, like a car, with the money:
    Take out 10,000. put it in the bank.
    Repay the loan with the money you put in the bank. Is anyone crying?
    No.

    If you paid for a car with the loan with a 401k loan. you pay the loan back with taxed money. So what? You would have paid for the auto loan with taxed money.

    The only real item is that you are taking out the 10,000 and then that money is not there to accrue interest and compound in your account.
    So your retirement will be less.

    But, that really depends on timing. If you took half of your money out in November 2008, and repaid it in April of 2009. you would have made 40%.

    Of course, usually what happens is a person takes it out in April 2009 and pays it back when the market is up 40%.. a big losing transaction.

  12. The best use can be to pay off credit card debt at 19-28% interest.

    You will likely NOT get that return in the market.

    At least if you dont pay it back, they do not take your house like with an equity loan.

    The problem is that if you just pay off your credit cards, and do not change your credit habits, you will fill your cards right back up
    and then you will have maxed out credit cards AND less in your retirement account.

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