financial gurus

[shnelson]

Couldn't find a specific spot on the forums to pose this thread, so hopefully this is sufficient.

I've been pondering taking out a loan against my 401k to pay off a vehicle loan. This seems like a good idea, so long as it stays disciplined and on track for re-payment as I understand there are significant costs to withdrawing from the 401k early.

If I understand correctly, the interest paid against a 401k loan comes back to me and does not go to a financial institution like a vehicle loan does. So, let's make the following assumptions (just throwing numbers out there):

Person buys a vehicle with a $20,000 loan through financial institution @ 3.9% APR. Monthly payments approximately $400 over 5 years.

At 2.5 years, loan is half paid down and over $1500 has gone to interest alone. Would it make sense to pay off the vehicle loan at $10,000, with a 3 year loan from 401k and interest rate of say 9.5%? The payments would be cheaper by about $100, and the 401k would gain about $1000 in the end (plus a cost avoidance of another $1500 going to the bank). I also understand that the $10k taken out as a loan would no longer be compounding in the 401k account, but it seems more sensible to pay myself interest in the long run rather than someone else?

Is there a good reason why not to take a 401k loan out? Just fielding for some answers here as I know there is a lot of knowledge on the forums.

Now - Please, discuss

[Comet]

Why wouldn't you get a 0% car loan from the mfg. I think there are several companies offering 0% financing right now. That is like getting free money without hassling with your 401K and all that red tape.

[CJH]

Straight from 401k Help Center.com:

The Pros:

1. It's convenient. There is no credit check or long credit application form. Some plans only require you to make a phone call, while others require a short loan form.

2. There is a low interest rate. You pay the rate set by the plan, usually one or two percentage points above the prime rate.

3. There usually are no restrictions. Most plans allow you to borrow for any reason.

4. You are paying the interest to yourself, not to the bank or credit card company.

5. The interest is tax-sheltered. You don't have to pay taxes on the interest until retirement, when you take money out of the plan.

6. You choose where the money comes from. The advantage of being able to choose which investment option you will sell in order to obtain the funds for your loan is that you can leave untouched those investments with the best performance.

The Cons:

1. There are "opportunity" costs. According to the U.S. General Accounting Office, the interest rate paid on a plan loan is often less than the rate the plan funds would have otherwise earned.

2. Smaller contributions. Because you now have a loan payment, you may be tempted to reduce the amount you are contributing to the plan and thus reduce your long-term retirement account balance.

3. Loan defaults can be harmful to your financial health. If you quit working or change employers, the loan must be paid back right away. It's not uncommon for plans to require full repayment of a loan within 60 days of termination of employment. If you can't repay the loan, it is considered defaulted, and you will be taxed on the outstanding balance, including an early withdrawal penalty if you are not at least age 59 ½.

4. There may be fees involved.

5. Interest on the loan is not tax deductible, even if you borrow to purchase your primary home.

6. You have no flexibility in changing the payment terms of your loan.

When You Probably Shouldn't Borrow From Your Plan

It is probably not wise to take out a 401k plan loan when:

1. You are planning to leave your job within the next couple of years.

2. There is a chance you will lose your job due to a company restructuring.

3. You are nearing retirement.

4. You can obtain the funds from other sources.

5. You can't continue to make regular contributions to your plan.

6. You can't pay off the loan right away if you are laid off or change jobs.

7. You need the loan to meet everyday living expenses.

8. You want the money to purchase some luxury item or pay for a vacation.

[shnelson]

I've been thinking about that too, the trade in value on my current vehicle is well above what I owe on it.

The only reason I'm looking at the 401k option is to pay off the balance on a vehicle I currently own... if I were to buy new I would definitely take advantage of the cash back offers and 0% financing.

[DTro]

The biggest negative is if you lost your job, not only do you have to pay the entire amount back right away, now you have to pay taxes and fee against the income.

[upnorth]

Not a financial guru here, but I will not touch my retirement funds unless it is a dire emergency. If something goes wrong with your job or something can be pretty darn costly, and I want to retire with a few bucks so I am not stuck at home on the couch.

[BobT]

I didn't know you could borrow against a 401K for an automobile. Aren't there specific restrictions about what you can use the money for? When I borrowed against mine to remodel my kitchen, I know that home repairs and remodeling was one of the few things the money could be used for.

Incidentally, when I borrowed against mine, I used money that was earmarked for low interest return accounts so in my case, the interest I paid to my 401K was more than the interest I would have received from the investments.

I'm surprised that the original auto loan, which was written 2.5 years ago, was at 9.5% and that you didn't refinance that loan a long time ago. I didn't know interest rates had been that high in the last 10 years.

Rather than risk your 401K you could consider a home equity loan. No down-payment, no closing costs (at least not at my bank), and you can stretch the loan out for longer term thereby reducing your obligation. For example, if you borrow $10,000 for 5 years, your payment will be around $200/month but here's where you use it to your advantage. Continue to pay the $400 you've grown accustomed to and you'll pay it off in about 2 years but if for some reason you find yourself in financial straits through job loss or something, you won't be obligated to the $400 payment, only the $200 payment. In addition, if you really get into financial trouble, because your vehicle is not the collateral for the loan, you would be able to drop full coverage insurance to save money in the short term. That alone would make the payment. Yeah, you'd have to accept the risk of driving with only liability during that time.

[harvey lee]

I agree the HE loan would be a good avenue to take.

I think I would keep the full coverage on though as one never knows what could happen.

Years ago I borrowed against a CD to purchase a new vehicle. The interest was like 2% over my CD rate. At that time it was cheap money. Thats if it is an option.

[hanson]

I've always been a big fan of taking out a loan to pay off a different loan. LOL! (sarcasm alert!)

As someone who is trying to untangle a bit of financial mess I've made for myself, one thing I've learned is there is no option that is easy or effortless.

I'm personally against Home Equity Loans and Home Equity Lines of Credit for reasons that should be dead freakin' obvious to everyone living in this country right now. Hello?? Foreclosure! For a source of credit, they are still probably one of the best options available but why on earth would you intentionally reduce the equity in your home during this economy? Lose your job, reduction in income, can't make 2 house payments now, oops... I'll just let it go. This is whats happened to sooo many people over the last few years.

If paying this vehicle loan off is that important to the OP, are there other ways to get the money to do it?? There are and they don't involve going into debt to do it. 2nd job, pick up a couple side jobs, sell some stuff you don't use, adjust your monthly budget.

I've personally sold off a bunch of outdoors stuff that hasn't been seeing the use it should and I've pocketed a bunch of money off it. Online auctions and C's list are great ways to get rid of stuff for decent money.

As for the budget, you'd absolutely be shocked as to how much money is "wasted" in a month on fast food, something quick at the gas station, restaurants, bars, liquor store, cell phone bill, cable TV, etc, etc. Make a budget, track your expenditures closely and you'll magically find an extra vehicle payment if you work hard at it.

Just want to present some thinking outside the box options that can help you accomplish your goal without taking on more debt to do it.

Some good books out there to help motivate a lifestyle change like this.

[BobT]

It wasn't the loans themselves that caused the financial problems we've been going through. It was leveraging too much of the income in order to get the quick way to the "good life" and not taking enough responsibility to have a realistic look at one's finances to see if they really could afford it. It was going into the situations with blinders on, listening to the fancy talk from over-zealous loan officers, and not paying attention to the fine print when it said, "introductory APR" or "balloon payment" or "variable interest." Suddenly they found themselves in situations where the payment they thought they could afford went up and over the top of what they could afford. As those irresponsible borrowers began to fall, the market took a hit and the train wreck began to cost jobs across the board and the problem grew worse.

We always face the potential of losing a job. I'm thinking that 99% of us or more on this site have used our home equity because I think it is pretty safe to say that very few if any of us have paid cash for our homes.

The suggestion of a home equity loan does not suggest more debt as Hanson has suggested. You either pay the original loan off as planned, refinance the vehicle at a lower APR, borrow from your 401K as you've been thinking, or consider a HE loan but in the end your debt is still the same $10,000. The one thing you can gain by this is that you have the potential to reduce your monthly obligation (reducing the risk of repossession or foreclosure) and save interest at the same time since 9.5% is really high by today's standards. Isn't that what you are after?

I wouldn't be afraid of a home equity loan if you've got your finances in order and don't leverage so much you can't make payments if there's a hiccup in your cash flow. That risk always exists and if you wait to borrow when it doesn't, you'll wait a long time. The HE loan would be for the amount of the vehicle therefore you could always sell it to defer the foreclosure. In the event that you would find yourself financially troubled, you'd probably have to sell it or lose it anyway to pay off the conventional vehicle loan if it meant saving your house. As already mentioned too, if you lose your job, the 401K loan comes due immediately.

Looks like you've got some decisions to make. Good luck!

[shnelson]

Great information so far, thanks everyone!

I think I needed to be more clear with my intents from the original post - this option was merely being evaluated as a 'smarter' use of money I suppose.

The APR on the vehicle loan is only 3.9%, it only equates to just over $500 a year in interest so I have no real complaints with it.

I would also like to clear up that there is no financial distress or emergency situation here. The payments are within a determined budget - Just looking at opportunities to get more bang for your buck.

My thoughts were to take the 401k loan out to pay off the vehicle loan completely (not incur additional debt), at an increased interest rate of 9.5% that gets paid back to my 401k fund rather than the 3.9% that goes to someone else with the current loan. I just threw 9.5 out there to try and compensate for the offset of $10k from the 401k account and how it would have compounded if I left it in there. Might be a better idea to bump it higher?

Everything you read about it is to only do it in an emergency situation, which this is not. A home equity loan is another option, but again you are paying interest to someone else rather than back to yourself. hanson I think you put it best, it does not make any sense in the current economy to decrease the available equity in my heaviest asset.

Here's another avenue to ponder -

Mr. Consumer wants to purchase a new grill for $500. He has cash in hand, but the 0% for 12 months that the retail store is offering seems too good to pass up. He also has the option to take the $500 from his 401k as a loan at an interest rate he decides.

So, Option A: Pay cash up front.

Pros: no debt, no credit inquiries or degraded credit score. A financially 'smart' choice

Cons: that $500 no longer collects the .02% interest that it normally would in his checking account. Mrs. consumer probably wanted to buy groceries or shoes with that $500.

Option B: Take the retail no interest card

Pros: No interest for 12 months, as long as approx. $45 is paid each month to satisfy the debt by the end of the term

Cons: Interest for the full purchase amount will be calculated if debt carries beyond 12 mos. Credit score takes a hit due to a new inquiry, and Mr. consumer now has another open line of credit that can be easily used on temptation and future offers.

Option C: Pull a 401k loan for $500, and pay 20% interest back to his account

Pros: Mr. Consumer will throw another $100 into his 401k all said and done

Cons: That $500 will no longer be compounding in his account, will the 20% accommodate this? If Mr, Consumer loses his job, he must immediately repay whatever the remaining balance is or force costly penalties with withdrawal fees. Finally, Mr. Consumer is paying tax on money he's putting into his 401k, since the loan payment is made after income taxes are taken on the amount. Would probably be better off not getting the grill, and increasing his 401k pretax with holding amount .

That's just a sample scenario to hopefully solicit some additional discussion around these 401k loans. Are they truly a bad idea if you are disciplined with your budget/spending, and can accommodate a job loss or financial disaster if it occurs? I can see how this utility is a bad idea for someone who is trying to pay debt with more debt (implying they don't have the funds to cover either in the first place).

[shizzy]

I understand where you are coming from, but the interest rate on your car loan is not bad. I would just reevaluate your monthly budget, see if you can trim a little bit and start sending more money to the bank each month.

I did that on my Truck loan and actually found it a bit of a personal challange to see how quickly I could get the loan paid off. It was amazing how many times I did not buy a cup of coffe or a cheeseburger with the thought of that loan being paid down in my head. I knocked over a year off the loan this way.

[harvey lee]

Another thing at this time is how much interest will you lose as the market is doing very well. One could lose 20% in a month on growth if the money was left in the 401k. Now, if we knew that the market was going to do nothing or stay flat, then maybe that's ok.

I have really enjoyed the ride back up in the 401 the last 3 months.

[marine_man]

One other thing to check on... some employers (mine included) stop making contributions to your 401K account if you take a loan on it until it's paid back in full; if that's the case with your employer you'll be paying yourself back the interest, but won't be getting the company match, which will add up.

marine_man

[LightningBG]

I wouldn't touch the 401K at all.

It boils down to will the 10k in your 401K earn more than the 4% you're paying out on the car loan? My guess is probably. (with this in mind, don't look at the increase in your 401K due to the interest your paying into the acct. You're pulling money out of one pocket and putting it in the other. it's not a return on an investment.)

(Another quick note: Chances are if the loan is halfway through the term, the loan isn't halfway paid off, at the begging you're paying lots of interest, at the end, very little.)

[SkunkedAgain]

The best advice that I can give is to think of your 401k as somebody else's money. There is no way you can/should touch it. There is no situation that dire unless we're literally talking about saving someone's life.

You can can some financial advantages in the situation that you described, but the intangible financial disadvantages are harder to measure. I buddy of mine took out a 401k loan to pay off a high-rate credit card. It seemed like a good move and he was making good payments. He had it half paid when a can't-turn-down job offer came his way. He took the new job but then took a massive hit on the loan repayment tax wise. In the end, I remember him telling me that he wished that he would have taken a different avenue to paying off his high-rate credit debt. To each their own though.

[BobT]

All good points.

In your Option A scenario you stated "no degraded credit score." Actually, if you stopped borrowing money today for the rest of your life, I believe your credit score will begin to decline for non-use. No records to support a high score equates into no score if I understand how it works. Also, what is negative about a credit inquiry? Finally, an added advantage with paying cash is that you owe nobody and you are most definitely living within your means assuming you have a job to pay the rest of your living expenses.

Option B also has the advantage of earning potential for that $500 while you use it to finance the no-interest loan. Technically, to do it right you would already have the $500 up front but accepted the retailer's offer to pay over time. Take the $500 and invest it and it can earn money at the retailer's expense. This way you also protect against the possibility that you might not have it paid off in time. In this case you could just retrieve what you need from the $500 you set aside and pay the bill.

[BobT]

Can you actually use a 401K account to finance a vehicle? If not, this all becomes a moot point.

[shnelson]

That's definitely a bind if the employer stops matching contribution when a loan is taken out.

You guys have raised some more good points, I like the out of one pocket into another analogy because that's about what it boils down to. If the market does pick up (which it should continue to do), it would be tough for any self paid interest to match what the 401k is capable of.

I think I can let this one rest now, it now makes very little sense to me to take out a 401k loan unless it is an absolute emergency and last line of defense. 401k loans can not be seen as an investment no matter what the interest you pay (one should simply increase their contribution by the same interest margin to get better results).

Now.. who wants to talk about short term investments???

[shnelson]

  BobT said:

Also, what is negative about a credit inquiry?

[BobT]

  Quote

I was told in the early stages while getting approved by our home loan that inquiries can cause it to drop, given enough of them occur. It was a while ago though, so maybe they just meant the bank would see them as a bad mark since it would appear to be an attempt to open more lines of credit in addition to a home loan?

Wait.. Just pulled this from About (dot) com:

Quote:

Part of your credit score – 10% to be exact – considers the number of inquiries made for your credit report. Credit inquiries are placed on your credit report each time a business requests a copy of your report.

/quote]

Interesting. My knowledge of credit reports and histories is very limited...okay...pretty much nil.

[LightningBG]

You're correct. For each time credit is pulled it dings your credit report a little bit. (2-3 points from what I have heard). Identifies people that are "fishing" for credit lines.

[Iceboy]

My feeling is that this is one of the worst times to tap 401k money (and I don't think you should ever touch it to begin with). We are in the middle of a recovery, and if things go as they should (no guarantees), your 401k money will grow much faster than what it will cost you to take out a loan. Interest rates are still pretty low now anyways, right?

Summary - don't touch your 401k. Ever. Social Security isn't long for this world, and you will need something unless u want to work until u are 80.

[Cads]

I wouldnt take money out of the 401.

The total interest on 20k (based on a 3.9% Int. rate & 5 years) over the life of the loan is only $2020.00. Most of the interest is paid back to the bank in the first half of the loan, meaning they already made their money. The later half of the loan is mostly principle.

Instead of paying off the loan, continue to make your $367/mo payment till the end. Even if you have additional funds left over, dont pay off the loan. Instead invest the additional funds into your IRA or buy mutual funds, gold, bonds, or stock, which is dependent upon your risk level.

The ultimate goal here is purchasing power. Debt is not always bad, especially when you have an interest rate at 3.9% fixed.

[Gatores]

I just quick read through the other posts, but I dont think anyone mentioned that you pay back a 401k loan with post tax money. Your normal 401k contribuations are from pre-tax money, but if and when you take loans from it you repay the loan from money after taxes. So when you end up taking the money out after you retire you pay tax again on that same money. So basically you are double taxed on your loan amount.

[delcecchi]

You get a loan from the 401k. no tax on principal. You pay back loan with after tax dollars which you would have paid anyway. You are now even. You didn't pay interest to bank. But you didn't get interest on money you loaned yourself. Instead you paid it to yourself. If the interest you saved paying to the bank is more than the interest you gave up, sounds like a deal.

A few minutes with a calculator or a spreadsheet should figure it out. Of course as has been pointed out by others if you get laid off or fired then you are in a bad situation.