401k Loan
There are many valid reasons why you would want to take a 401k loan. The goal of your 401k is to save money for retirement and nothing else. However, often taking a 401k loan for a valid reason saves you money in the short-term and may even increase your long term savings goals. Most advisors and conventional wisdom suggest that you should never take a 401k loan, but this advice is really not based in fact. The thinking is that if you take a loan and lose your job before the loan is paid back, you will have to pay a penalty on the loan amount. However, as you will see below, the benefits of taking a loan far exceed the potential risk.
Purchasing a Home
Many people take out a 401k loan to pay for the down payment on a house. For most of us when we are first starting out, it can be difficult to save up enough for the down payment. While I don’t blindly subscribe to the notion that it always makes fiscal sense to own a home, if this is the route you are going to take there is absolutely no reason why you should use a portion of your 401k to make this purchase.
In fact, you have two options when purchasing a primary residence:
401k Loan: You may take a loan from your 401k to pay for as much as your home as you choose. You will have to repay this money into your account to avoid paying taxes and you will also have to pay a moderate interest rate. However, the interest you are paying on your loan will go directly back into your account. You don’t need to provide a reason why you are taking a 401k loan, and the loan for this purpose is no different than any other type of loan.
401k Withdrawal: Instead of taking the 401k loan, you can simply withdrawal the money and pay the penalty of 10%. This is only the better option under very specific circumstances and you should strongly consider taking the 401k loan before you take an actual withdrawal. Most 401k plans only allow you to borrow up to half of the value of your account and you can only do this once. You will most likely not be eligible for a loan again until you have repaid the first loan.
You have to weigh the benefits against the costs to your retirement and the immediate costs in terms of penalties. For some, these costs will be less than the cost of the mortgage and mortgage insurance. For example, if you putting down a larger down payment allows you to get a discounted interest rate or eliminates the need for mortgage insurance, this may be the best choice. However, even then it is only the best choice if using your entire 401k makes a bigger difference than using the 50% you are eligible to receive as a loan.
The other reason why some would choose the withdrawal instead of the loan is if they cannot afford both. However, in this circumstance I would encourage you to find a cheaper home or hold off until you can easily afford the home you want.
Purchasing a Car
The vast majority of financial advisors will tell you that using a 401k loan to purchase a car is a horrible idea. They will give you all kinds of statistics about the worst case scenario and how you could lose all kinds of money if you lose your job while the loan is still active. This is completely true, but let’s look at the actual numbers:
Let’s say you want to purchase a $25,000 car and the banks quote you at a 5% interest rate. For this example, the $25,000 is the total purchase price including taxes and other fees. There is no down payment or trade-in. We will also assume you are going for a five year loan. We will also use a 3% interest rate for the 401k loan, but remember
Bank Loan
Payment: $472 per month.
Interest: $3,307 over 60 months.
Total Cost: $28,307
401k Loan
Payment: $449 per month.
Interest: $0
Total Cost: $25,000
Some would argue that the above numbers are not accurate as the money you use to purchase the car will not get a return on investment for the length of the loan. However, you are paying 3% interest which will help boost your account and you are saving 6%. This is really no different than getting a 6% annual return on the money you used to purchase the car.
Credit Card and Other Debt
Of the reasons to get a 401k loan, this is the most controversial. The vast majority of financial gurus will suggest that you should never use hard assets to pay for unsecured debt. They make a strong point, if things go extremely wrong in your life, you would rather have the hard assets. Simply, you can always default on unsecured debt and retain your nest egg. However, for most of us this is not a real concern if we have a career and insurance to cover us if we become ill.
Once again, the case to not do this is very strong, but when you look at the numbers you will quickly realize that there is a compelling case to use the 401k loan for this purpose.
For this example we will suggest you have $25,000 in credit card debt and have an average interest rate of 10%. We will use an industry standard to determine the minimum payment and assume the most you can afford is the minimum
Pay Credit Card Debt Directly
Monthly Payment = $695
Months to Payoff = 43
Total Payments = $29,885
Total Interest Paid = $4,885
Pay Credit Card Debt with a 401k Loan
Monthly Payment = $695
Months to Payoff = 38
Total Interest Paid = $0
By using the 401k loan you will be out of debt five months sooner and save nearly $5,000. It is up to you to determine if getting out of debt sooner and savings this amount of money is worth the risk. You will also have to consider if there is anything else that could come up over the course of the 38 months that will require a 401k loan for a different reason such as purchasing a home.