Friday, July 13, 2007

Why Not Borrow Against 401k?

I have never read of any financial planner that advocated borrowing against your 401k. In fact, 100% of everything that I read says to never do this. I do not understand this at all and wonder why.

I have borrowed against my 401k since this was allowed. In my 401k I have two options for investing. One is a fixed income fund that currently is paying ~5.75% interest. This is the closest option I have to a bond fund. The second option is some mutual fund or my company stock.

When I borrow against my 401k I am paying (currently) about 8% interest on the loan. Essentially, I have created a fixed income investment for my 401k that pays 8%. It seems to me that this is a better return than the fixed income fund that is my alternative choice. Since every financial planner is advocating that I have 30% of my 401k in a fixed income fund, why is the loan fund not a better deal than the fixed income fund offered by my company?

Now, you can argue about the merits of borrowing money, but if you need to borrow money anyway, why not pay yourself rather than a bank? It just makes more sense to me that the first place you should borrow is your own bank. And that is what my 401k is - a bank that makes investments.

The major risk is that you will change or lose your job before the loan is paid. For me that has not been an issue, but for young people who feel the need to switch jobs or people in unstable industries, I can see that point. The risk of having to repay the loan with a 10% penalty is steep.

For me this program has worked out great. I've borrowed to buy houses as well as other short term needs (usually for investing). I wouldn't think that borrowing to buy an HDTV is the thing to do here (but that is a completely different issue), but it is an option that can pay dividends.

So, am I missing something or does this make sense?

See part 2 here
Also see this webpage Using 401k Loans for Real Estate Purchase

67 comments:

Anonymous said...

07/13/07 Paul, I assume you are in a safe job with a solid company,have significant retirement savings,have run the numbers and think the loan rate is a good deal, and can pay it back within (5) years,then go for it. But I am concerned at your age--you're looking at retirement real soon relatively. Are you giving up the ability to have your 401K gain, while your real estate ages on the market? Be very careful, especially in these shaky economic times. The only thing for certain is that you're going to get older and retire if you are lucky.

Paul said...

Sure I am giving up some opportunity to have the loan money invested in the stock market but according to financial planners I should be doing that anyway. In fact, at my age I should have more money in "safe" bond funds per the planners, but I am trying to play catch-up due to losses caused by my divorce.

Anonymous said...

Paul,if I were your age and wearing your shoes,I would forget all about "safe" funds, choose a stock fund with the best yield, put your money there, and let it ride until the market significantly changes, especially if you are playing "catch-up." I also assume the financial planners work for someone else and not you. Otherwise, their advice would be personalized and not generalized. Only you know the answer. Take care.
07/16/07

Steve said...

Hi Paul- Your question is interesting... I'm no expert with 401(k)'s and you sound pretty versed. I agree with Anonymous regarding giving up 401k gain... And here's a quote I came across from 401k.org on 401k loans that makes me wonder of the value of doing it:

"There is a popular misconception that paying back a plan loan is like "paying yourself." Unfortunately, this is not true. When you take a loan from your plan, you are withdrawing money from your account balance and replacing it with an IOU. That IOU continues to generate interest from your repayments, but generates no special investment return.

In a sense, all fixed investments are a kind of loan. You are lending money to the government or a corporation through the stable value, money market or bond funds in your plan. However, the return (or interest) generated from these loans comes from a borrowing party. When you loan yourself the money you are simply replacing the interest you would already be receiving with interest payments from yourself."
Is this relevant from your perspective? Or do you see it as negligible... just wondering.
Best wishes in the future!

Paul said...

Your last paragraph is what gives me a sense that borrowing money from your 401k is good. Yes, I am paying the interest to myself. But assume that it is a given that I need to borrow and I WILL pay interest to someone. Who should I pay that interest to? Myself (and boast my 401k return) or some big bank?

MRWCFP said...

The interest you pay is infact to yourself. That makes it seem like a good idea. Financially, it's not that smart. Here's why. You paid ZERO tax to put the money into the 401k (assuming pre-tax contributions were made) and no tax to borrow money (so-far-so-good). However you pay full income tax on the amount you put back into the 401k and then you pay full income tax again when you withdraw later on (in retirement).
So if you borrow $20,000 from your 401k and you are in 28%/5% state tax, you need to earn $30,000 to put $20,000 back into the 401k to repay your loan. When you withdraw that $20,000 in retirement, you pay tax again. Assuming similar tax bracket (a common scenario) you loose another $6,600.

Don't be jaded by the fact that you pay interest to yourself. YOu pay more to the IRS. Don't borrow from your 401k.

Paul said...

I'm in a much higher tax bracket now than I will be in retirement. I'm paying taxes on money I pay to the bank on what I borrow now, so your first arguement makes no sense. The time value of money will make the interest I pay in taxes at some future point almost negligible, so I don't buy your second arguement either.

Anonymous said...

I agree with your analysis completely - what did you decide?

Paul said...

I use my 401k to buy properties, not for luxuries. I think of the interest I pay myself as a bond fund.

Anonymous said...

Even though you pay your 401K loan back with taxable income (ie you need to make $30K in income before taxes to pay back a $20K loan with interest) I think your idea of borrowing for property investment could make good sense in certain circumstances.

For example, if borrowing from your 401K allows you to put a down payment on a property and qualify for a loan for the balance then you will be deducting the interest cost of that loan from your taxable income. So, you still get a tax-deductible benefit AND ALSO the greater leverage a real estate loan offers that you will never get in your 401K. Your $$$ are definitely working better for you in this scenario.

P.S. I am not the same Anonymous that made the original comment.

Anonymous said...

I work for the government and on our 401K site (TSP.gov) I used their "Project your account balance calculator" to determine if it made sense for me to take a loan from my 401K. I currently have a 401K loan for 28,000 over a 15 year term that I am currently paying back at an interest that is 2% of my income and contributing to my TSP at 7% (for a total of 9% of my income). The calcutor tells me that if I were to pay off the loan now (in other words increase my account balance by 28000), lower my contributions back to the original 7%, and let my new balance grow over 15 years, that I would have less money at the end of 15 yaers than if I kept the loan and contributed 9% over 15 years. Its a free website, try it with your income and loan amounts to see if you come out the same. Bottom line - I agree taking 401K loans make since as long as you pay it back at an high enough interest that your change in final balance over the term of the loan is less than the interest you would pay to a bank for the same loan.

Anonymous said...

What MRWCFP was getting at was that the money you put into your 401k comes from pre-tax dollars off your income. When you borrow against your 401k, you then pay it back with after-tax dollars - income you have actually received. When you later withdraw from your 401k after retirement, you pay tax on the money you take out. Therefore, in the end, you effectively pay taxes TWICE on your loan amount.

Paul said...

If you assume that I don't need to borrow money you are right. However, if I must borrow money, I am paying off that loan with after tax dollars, so I don't see the difference. If I don't pay myself the interest, then I will pay a bank or CC company a higher interest rate. Depending on your tax backet, the discount I get by borrowing against my 401k may wash out with any taxes I pay on the interest my 401k earns.

Bobby said...

Unless you're only other option is a high rate CC, I doubt borrowing from your 401k will make much difference. You are giving up the opportunity cost of the 401k money (5.75% fixed income fund in your case) which offsets the interest you "pay yourself". Even if you pay yourself back at a higher rate (e.g. 8%) that excess is double taxed as others have pointed out. You therefore would have been better off keeping the excess outside of the 401k.

One more thought, 401k are typically shielded from creditors in bankruptcy cases. You default on a bank loan, they can't touch your 401k. You default on a loan from your own 401k, well then you have no retirement money...

Anonymous said...

If you use the loan from the 401k to purchase Real Estate (primary home). You're getting the benefit of living in the home and the appreciation of the home. In some areas, this appreciation will outpace the gains you would have recieved if you left the money in your 401k. In a sense, you're using that money for a REIT which is usually not a choice available in a 401k plan. You're also using leverage with the borrowed 401k money. If the money is left in the 401k plan and invested in a mutual fund. You're not leveraging the total amount in the same ratio.

On the sell-side of the home, you'll hopefully make enough to pay off the 401k loan and have money left over (profit). You will not pay taxes on this profit if it's under the $250k limit and will have benefitted from this gain tax free. So using money from a 401k for real estate is still a good proposition if it's your primary residence and the home is in a good area with a healthly outlook for appreciation.

Anonymous said...

I appreciate your willingness to challenge the conventional wisdom on this issue. I don't understand the whole thing myself. If you borrow from your own 401k, why would you ever pay it back?

Paul said...

If you don't pay it back its considered a withdrawel. You taxes on the withdrawel just like its income plus up pay a 10% tax penalty on the amount withdrawn. Never withdray money from your 401k.

There's no tax penalty for borrowing the funds.

rwfree said...

I need to borrow from a 401k from a previous employer. I never rolled it over. Can this be done?

Ray Ray said...

Hi Paul,

Thanks for opening this topic for all of us. Currently I am planning to buy my first home in this summer and I am seriously thinking about borrowing money from my 401k plan (provided my own small consulting business) because I don't have enough cash for a sizable down payment. There are many articles online saying that it is a bad idea to borrow money from your 401k. Here is one of the articles:
7 Reasons Why Borrowing From Your 401k is Bad, Bad, Bad! (http://www.gatherlittlebylittle.com/2007/07/17/7-reasons-why-borrowing-from-your-401k-is-bad-bad-bad/)

1 - You are borrowing against your future
Yes, but I am also investing in a home for our future.
2 - If you leave your job voluntarily or not, the full amount is due immediately
True, it is valid for an employee. But I own my consulting company so I won't fire myself as long as my business is stable.
3 - If you can’t pay the loan back, the unpaid balance is treated like distribution
That is a risk but I guess the general rule (or the lesson we all learn from the subprime mortgage crisis) is not to borrow more than what you can afford. BTW, the loan limit is only $50,000 or half of the total amount in your 401K, whichever is lower.
4 - You pay double taxes
I guess this is true only if you are borrowing for a primary residence since the mortgage interest you pay to a bank is tax-deductible. According to the IRS (http://www.irs.gov/publications/p530/ar02.html#d0e587), “the interest you pay must be on a loan SECURED by your main home or a second home. The loan can be a first or second mortgage, a home improvement loan, or a home equity loan”. So the 401k loan is not a loan secured by your home and it is not deductible. Here is an article from 401khelpcenter talking about the interest deduction: http://www.401khelpcenter.com/faq/faq_41.html
However, another article from USAToday said even a loan from your parents for down payment is deductible: http://www.usatoday.com/community/chat/2002-02-14-bohle.htm
This is very confusing. Is there anyway we can create a second mortgage using the 401k loan? Does it worth the work?? I really not sure.
But, if you borrow the money for a new car, a HDTV, or other items, you still have to pay post-tax dollars no matter to a bank or to yourself. So you will be subjected to double taxes on consumer goods anyway.

5 - Starts a bad habit
It is all about self control. So all home owners with a mortgage start a bad habit then??? Borrowing is a tool for many people, businesses, even countries to invest, and grow. Borrowing is actually one of the greatest inventions for our economy.
6 - Some plans make you stop contributing while your loan is outstanding
My plan doesn't do that.
7 - Some plans charge a fee for loans
My plan charges me $75.

So here is the bottom line: it is not easy to get a mortgage from a bank nowadays if you don't have a decent down payment. So if you can borrow more from a bank that's great. If you can't there is no choice but borrowing from your 401k.

I guess the key of the topic is if the interest payment on the 401k plan is deductible or not.

Paul said...

When you take out a 401k loan for your primary residence you can get a 10 year term, otherwise you can only get a 5 year term. Not sure why that wouldn't be tax deductible but I'm not an accountant.

Great summary Ray Ray

Anonymous said...

Paul, Thanks, for raising this topic. I have always thought it is a good idea. I think it makes even more sense in today's economy.
I need some money to meet an unexpected expense. My current 401-K and my savings portfolio are both not doing so well. I do not want to withdraw from my savings (most of them in Mutual Funds that are losing money) at this time.
To me, it seems like borrowing from 401-K seems like a good deal.
By withdrawing I will be "protecting" some of my investment from losing its value, since I am paying interest to myself, I will be saving even more. Eg., if I borrow $100 for one year at 7% my balance will be $107 at the end of the year. As far as the argument that I will be paying "after tax": if I borrow from any other source, I will be paying back "after tax" too, and at the same time I am paying someone else the interest.
Any thoughts?

Paul said...

You raise the same benefits that I have spoken of. I guess the main question you have to ask is the purpose of the loan.

My 401k loan earnings are doing better than the other 80% of my investments this year as well.

Anonymous said...

Double-taxation is a real issue, but you are only double-taxed on the interest you pay back to your 401K. The loan principle is effectively post-tax money when you get your hands on it, and is repaid with post-tax dollars. The problem is the new dollars you are putting into a 401K through interest are post-tax, and those dollars are taxed again at retirement.

Paul said...

You could make the same argument with all the earnings in the 401k - they are all post tax. e.g. the dividends were paid after the corporation paid very high income taxes on their earnings. My personal income tax rates are much lower than corporate tax rates.

From a "bond" type fund perspective, my account is better off earning money from consumer (i.e. me) interest.

Anonymous said...

ok, to throw another wrinkle in the mix: what if my employer matches 401k contributions (up to 4%). Wouldn't that effectively cut the net "cost" by 4%?

Paul said...

not sure I understand how employer contributions effect your loan. For my account, I don't believe I can withdraw employer contributions as a loan.

BT said...

I am seeking advice on this topic. Thank you in advance for opening this up. Basically, if you were in my shoes, what would you do?

I have an 80/20 loan on my mortgage. $148,000 w/ one lender. $30,000 with another. My wife has a $12,000 college loan and I have a $15,000 college loan. We have a $5,000 line of credit. My wife doesn't work.

I'm considering borrowing against my 401K to pay off one of these loans because things are really tight right now. Because the 20% mortgage is at 7% interest and $255/mo., I've considered borrowing money to pay that off. Would I be allowed to pay this off in 10 years?

Otherwise, paying off the college loans is enticing because they currently total $330/mo for both college loans.

However, if I borrowed $30,000 from my 401k, what would my monthly payments look like? Would it still be around $300/mo?

Thank you.

Paul said...

I don't know if all 401k's are the same but for mine you can only get a 10 year term for the purchase of primary real estate, otherwise you have a 5 year term. I don't think you could get a better interest rate or terms than you have for your second now. If you wanted to pay off college loans you could only get a 5 year term and the interest rate might be higher than you have now.

ADCPA said...

I have been a CPA for 27 years and Personal Financial Specialist( a designation earned through the American Institute of CPAs) for 10 years. I agree with Paul on every count. If you are going to be paying a bank or other lending institution 7% anyway, why not pay yourself. You will be paying any loan with after tax dollars so I don't think that is relevant. If you opt to borrow at 7% from another source other than your 401k and your 401k appreciates 7% than you are in the same boat as if you had borrowed the money from your 401k in the first place so the argument about paying with after tax dollars being a negative doesn't hold water. If the loan is not collateralized by the home then it is not considered home equity indebtedness and is not deductible as such. If the proceeds are used for another purpose, such as investing in stocks or bonds, then the interest might be deductible as investment interest or some other type of interest which is probably beyond the scope of this discussion.
Hope that helps.

Anonymous said...

Hello, I am also considering borrowing against my 401K to help alleviate some of the stress caused by this economy. My credit cards are at maximum and my Mortgage is high and set to reset in October. I can't get a personal loan to pay down or consolidate some of this debt. I only have about $18,000 in the plan. Yes I am a youngster. Does it make sense to borrow like 5,000 now and place most of that back during Tax time?

Paul said...

Wow - this looks like the worse scenario to take out a 401k loan in my opinion.

If you are expecting a windfall at tax time, why not change your W-4 and have more take home pay now to pay off your debts in a "snow ball" method?

Anonymous said...

ADCPA says "If the loan is not collateralized by the home then it is not considered home equity indebtedness and is not deductible as such." What is the collateral when you borrow money against your 401k for the purpose of buying a home?

ADCPA said...

The collateral would be the home and if you are buying a home the interest on up to $1,000,000 of principal is deductible as acquisition indebtedness, although the limit on borrowing against your 401k for buying a home is significantly lower. I believe it is the lesser of 50% of the value of the home or $50,000.

Anonymous said...

ADCPA - great insight. Anonymous3 here.. I have a very important question. I have three 401k accounts. One with $40k and two with about $100k in them, of which, one of the $100k 401k's I actively contribut to via my current employer. I am buying a house in an exclusive area at a great price ($1.3M, which is 20% below market). I understand that 50k of borrowing from your 401k is the limit. But since I have multiple 401ks (I never rolled them), can I borrow from 50% or 50k for each one of my 3 401ks?

ADCPA said...

I haven't had your situation before, nor have I researched it now, but I would be shocked if you could get around the rules by using 3 accounts.

Bruce said...

This is a great discussion!

I'm currently looking to buy my first home in the SF Bay area. We all know the news about the meltdown right now but believe it or not, I only just yesterday got pre-approved! I have the FICO score and everything else but the car paid off. Now I need to conjure up some cash for a down payment from somewhere. I'm looking at what's left in my otherwise underperforming 401(k) account.

In the course of this discussion, "adcpa" wrote:

"The collateral would be the home and if you are buying a home the interest on up to $1,000,000 of principal is deductible as acquisition indebtedness, although the limit on borrowing against your 401k for buying a home is significantly lower. I believe it is the lesser of 50% of the value of the home or $50,000."

I would suggest that there is an inference that 401(k) loans are tax deductible when used for a home purchase. Tread lightly there. According to the FAQ page on my fund administrator's website, on the question of whether or not 401(k) loans are tax deductible, there is a one word answer. "No." There's no qualifying statement about when being used for real estate acquisition. The reason most 401(k) loans are limited to 50% of the balance in the account is that the only collateral is the rest of the balance. The bigger difference between two types of loans (general purpose and real estate acquisition) is the terms of the repayment period. In the case of my 401(k) plan, that's up to 15 years. General purpose loans being limited to five years. I have to submit documentation related to the real estate purchase, to get the 15 year term.

While I am aware that dipping into the 401(k) is treading in dangerous waters, I also know that I have waded in this pond in the past. Bad debt, i.e. charge offs, drop off the credit report after seven years. The statute of limitations on collectibilty expires anywhere from four to six years, depending on what state you live in. DO NOT borrow from your 401(k) to stave off bad debt. Time will take care of that.

Thanks for listening and letting me share.

Bruce.

empee said...

I'm currently looking to purchase my first home. I'm 31 years old and have been contributing to my 401k for about 8 years, though it has actually lost money over the last couple years.

I've read plenty about the negatives of borrowing from your 401k, but I'm still intrigued by it. I am approved for a loan, and have enough to put the minimum downpayment for an FHA loan.

My question is: would it be bad for me to borrow from my 401k to get a much bigger downpayment? Is there a time when it's better or worse to borrow from your 401k? Namely, with the market in the proverbial toilet right now, is now a better (or worse) time to borrow from your 401k than it would have been in January of 2000? Or does that have no bearing? I've seen the total value of my 401k fall and fall over the last 18 months or so, so it's kind of disheartening to keep pumping money into it, even though I do realize that it's a long-term investment and over time it should go back up.

Anonymous said...

the money you pay back with "after tax money" could be the same money you took out on the 401k loan (this hasnt been taxed). So you are only really paying taxes twice on the interest you are paying yourself. This is better than taking a loan from a bank. At a 6% interest rate the extra 31% taxes you lose is only about 2%. A 2% loan sounds good to me!

Paul said...

Well, I looked at my on-line 401k statement today. Glad that my 401k loans are a large share of my portfolio. Everything else I invested in last year had tremedous loses

Scott said...

I too took a small ($4,000, or roughly 25% of my retirement account) loan against my 401k last year to pay off some credit card debt. I took this before the market tanked and right now I feel like a genius. I protected all of that borrowed money from stock market loss and I'm buying back in at better market prices.

In addition, the idea that you're repaying your 401k loan (pretax dollars) with after-tax dollars is somewhat flawed.

It's true in one sense. The money you're using to repay the loan has been taxed. But I was able to remove $4,000 in untaxed money and use it for any purpose I chose. That was TAX FREE. I was never taxed on that income yet still used the money. So if I repay it with already taxed dollars, I'm merely breaking even, assuming my tax bracket hasn't changed.

The only negative tax consequence comes on the interest you pay against your 401k loan.

That interest (say 6% annually in my case) is being repayed in taxed dollars, which will be taxed again when withdrawn at retirement.

If you're in a 35% tax bracket at retirement (most of us aren't this high), you're paying an additional 2.1 percentage points in income taxes that you otherwise wouldn't have to pay.

This rate - 2.1 percent - certainly beats the rate on my credit card (16.99%), which is also normally paid with already-taxed money.

So my only losses are the 2.1% extra that goes to the government and any potential gain my borrowed money could have earned in the stock market.

Considering my investments dropped by roughly 40% after I took my 401k loan, I have so far realized a savings of $1,600 (minus 2.1% additional taxes), as long as I can reinvest before the market swings back up.

Anonymous said...

Does anyone here have a comment on using money ($6000) borrowed from a 401k to deposit in a Roth IRA?
I want to have more investment options, including ETF's, Ultra short and ultra long funds, etc,, that are unavailable to me in my 401k. If I were to lose my job, I withdraw the funds from the Roth to repay the loan, keeping any gains in the Roth. I know I could also lose value, but thats a risk I'm willing to take on this amount of money. If everything goes to plan, I with have funded taxfree retirement income and gained interest income in my 401k. I plan to keep contributing to the 401k at about 15% of pay to get the employer match.

Any problems with this scheme?

--Anonymous99

Spanky said...

Excluding, the job loss scenario, a major point here is whether or not the interest you'd pay to a bank is greater than or less than the difference in an expected equity return and the loan from the 401k.

If you were planning on investing the money in the market you'd expect 13% about(or use whatever number you want). If you borrow it you will earn 8%. Your loss is 5%. A private loan would probably charge you more than 5%.

So by borrowing against your 401k you actually end up losing less than borrowing from a private bank. There are new risks though. Instead of market risk you have job risk.

Paul said...

I wish I could get 13% return on my 401k investments!!

There are no funds in my 401k plan that have more than a 55 return over the past 10 years

Clymbon said...

I'm wondering about borrowing from my retirement fund. A couple of questions:

First, I don't actually have a 401k. Rather, I have most of my retirement savings in a 403(b) and some in a 401(a). I don't know about the 401a, but I think the rules for borrowing against a 403b are about the same as for a 401k. If anyone knows otherwise, please let me know...

OK, so I'm considering borrowing against my 403b so that I can pay down my house mortgage in order to be able to refinance with a lower rate. Right now I've got a 530K mortgage at 6.25% on a house that would probably appraise for about $630K. If I borrowed $113K from the 403b, that would allow me to bring the mortgage down to $417K, which would be considered a conventional loan in this area. If I did that, as of right now, I could get the rate down to perhaps as low as 4.8%, as opposed to 6.25% I'm paying now. So I'd save 1.45% on $530K annually, or $7,685 per year (initially). That's enough to pay back the $113K over, say, 5 years. So the end of 5 years I'd have the 403b loan paid off, I'd have a lot more equity in the house, AND I'd have been making lower total payments for those 5 years. Sounds like a good idea so far...

Where I start to get lost is on the tax implications.

Does this sound like an idea worth pursuing? Maybe time to bring in a professional financial planner!

Paul said...

You probably won't be able to deduct 401k interest on your tax return.

If your mortgage is held by Fannie Mae or Freddie Mac you might be able to use Obama's home assist program

Anonymous said...

I have an unusual scenario that I'm thinking about. I'm thinking about borrowing against my 401k to provide a cushion of cash to go into business. I am an experienced OTR (over-the-road)truck driver and would like to buy my own truck. I have 16yrs experience as a company driver. I have enough money in personal savings to buy a good used truck, buy a new APU (a generator to eliminate idling away the fuel)and get an aftermarket 3yr warranty to cover major repairs. I can pay cash for all that (without touching my 401k or Roth IRA) and have a few thousand left over (less than $10,000). Problem is (if you're being prudent) you need to have 6mths of operating and personal expense (approx $20,000) as a cushion. I have approx $40,000 in my 401k and could borrow $20,000 as I understand it. Another problem is I was laid off a few months ago (am on unemployment/and my books are balanced)and I understand you can't borrow against your 401k w/out a job. (Getting a loan to get a truck is not a problem for a laidoff truckdriver if he has good credit, which I do, if he goes thru a loan outfit that's familiar with the industry.) But that doesn't help me with the 401k loan. What do you all think about getting the truck and getting signed up as an owner-operator and THEN taking out the loan? Is an independent contractor considered the same as being "employed" for purposes of getting access to a 401k loan? My other question is: is the interest rate always at or slightly over the Prime Rate like I read on another website? I checked and it's 3.25% now. Also do you have to have collateral for your own money?? Some people have mentioned something about that in relation to buying a house. What about needing one for regular loans like this (I don't own any real estate)? And if so could the truck be used for collateral? I really just feel I need the money for a "line of credit" type of thing. If things go reasonably well I may not need it at all but most new businesses (of any type) go under in the 1st year or so due to under capitalization (which I"m determined will not happen to me). What do you think about these issues? Thanks Everyone!.....(Addit. info: I'm single, have no debts of any kind or alimony/child support. car paid for, very low rent (parents house). I have $50,000 in a Roth IRA and am planning on [when I can] paying the income tax and rolling the 401k into the Roth [like I did last job change 7 yrs ago]. I have ran my credit score at all 3 credit bureaus and it ranges from 757 to 792. I have no bankruptcies or anything bad of any significance on my credit reports. I just want to do this right and I despise debt but have considered "peer lending". Anything to get a low rate-but Prime Rate sounds like the best option.)

Paul said...

the first question you have to answer is whether or not you are eligible and if the administrator of your 401k will allow you to borrow.

Anonymous said...

I am looking at buying a home with FHA financing. My credit is great and my income is fairly high. I am getting close to a DP for the home, but it would make it MUCH easier to just borrow about $5-10k from my 401k. This would make the buying process very stress free. I have read most of the comments and I do feel pretty good about this. I am confused about the pay back. If my 401k requires I pay back the money + 7% interest (for example), and I maintain my current 6% contributions, is all of the money put back into my account pre-tax?

Or do they take the 6% contribution pre-tax and the loan+7% post-tax?
-- I put the money in pre-tax, I am borrowing it with no tax, don't I just put it back in no tax?

-Mike (ohio)

Anonymous said...

I love this topic. Thanks to everyone for posting. My company is about to offer a Roth 401k. I am excited about that prospect but don't know the rules yet. I am trying to figure out if I can borrow from the pre-tax funds to fully fund the Roth side. I don't have enough money in my budget to fund the Roth but don't want to miss the opportunity to sock away $16.5k in retirement per year. Does anyone here have experience with this?

Anand said...

I am also considering borrowing against 401K. My argument is that we can consider the double tax on the interest as cost of the loan.

For example, if I borrow 50,000 against 401K at 8 % for 2 years. My cost of 401K loan can be calculated as (50,000 * .08 * 2 * .25) = 2000 $

While for the same loan from a bank that is giving me 4% rate the cost is,

(50,000 * .04 * 2 ) = 4000

So you can argue that borrowing from 401K is only half as costly as borrowing from the bank.

Financial Advisors do not want to borrow from 401K, because their employer want to control your funds.

Anonymous said...

i am doing it even as we speak.........taking a loan against 401k,,,,,,,why not? worse case u lose ur job and the money....best case u pay it back and get the money and interest back and then retire...its like double o nothing haha

Anonymous said...

Anyone who borrowed against their 401k about 2 years ago when DJIA was at 14,000 made out very well - the money they took out didn't tank in value 50% like the money they left in.

There are always two sides to every coin...

Anonymous said...

Anand why is you multiply by .25 when figuring the cost of borrowing from your 401k? what did I miss there?
50,000 * .08 * 2 * .25 ??

Anonymous said...

Looking for advice. I'm 28 years old and obviously plan on working for a while. I have $20K already invested in my 401k, however my spending habits haven't been great in recent years and I also currently owe about $20K in credit card debt. I feel like my job security is better than most, and although our company has had to cut back on salary increases, I forsee a promotion within at least a year which would effectively raise my salary at least 20%. The credit cards I have accrued debt on range from 7% on about $10K, and up to 15% and 18% on the remaining $10K. It's been impossible for me to pay off the balance with the interest each month. It seems to me borrowing against my 401k would definitely make the most sense because
1 - the interest would be lower than the credit cards
2 - although I wouldn't be earning a return on continued 401 payments, I would still earn on the remaining 50%, pay off my high interest credit cards with the 50% I borrow, and pay that back from my payroll.
3 - If I'm able to adjust my contributions (between 401k investments & payback to the loan) to offset and keep my net take-home salary the same,this will provide me much greater flexibility in paying off the remaining 7% credit card debt.

I don't need any comments on my bad spending habits to date, but if anyone has any feedback beyond that (whether it's in support or against my thought process on 401K borrowing), it would be extremely welcome.

Thanks in advance.

Paul said...

I don't think using a 401k for credit card debt payoff is a good idea.

I'd sugget cutting up your credit cards and starting a debt snowball

Anand said...

Paul,

"For example, if I borrow 50,000 against 401K at 8 % for 2 years. My cost of 401K loan can be calculated as (50,000 * .08 * 2 * .25) = 2000 $"

In my calculation of cost of borrowing from 401K, I take 25% as the tax penalty I have to pay.

I have to pay 8% interest per year to my 401K account, but it is paid from the after tax money. When this money is finally withdrawn from 401K, the income tax has to be paid again. So to simplify the calculation, I just assume 25% tax penalty that is not there when you borrow from say home-equity.

justinpigott said...

Paul,

I agree with all of your points regarding borrowing against your 401K when you have a solid job situation and you have to borrow the money from somewhere. The only point that I believe is being overlooked is that fact that when you borrow against the 401K funds then that money is no longer growing for you and the impact of this is not limited to the 5 years until you pay it back because that is offset by the interest you are paying yourself but rather for the length of time that money would have compounded.

For example if you borrow $10K and pay it back in 5 years with interest and then let it grow for another 25 years compared to not borrowing against it and letting the original $10 grow 30 years, then in the end you will have $15K less in your account when it comes time to retire. So it cost you $15K to borrow $10K vs the $2K in interest it would have cost you to borrow from a financial institution.

Clearly if you are older and you don't have this many years left of compounding and your investments are more conservative at this point then it is will have less of an impact and may make more sense. But many of the comments have been by people in their 20's in which case it makes no financial sense what so ever to borrow against their 401K with the one exception being if it is the only way to get a home loan in which case the equity over time in their property and the tax saving would more than make up for it but this should be their last resort.

justinpigott said...

Paul,

I should clarify a couple of items on my calculations. I was assuming the $10K that was borrowed against would not grow until it is completely paid back so that there would be 5 years of no growth on that $10K until the end of the 5 years when you would now have $12K (based on 8% interest)and then the $12 would grow for the next 25 years. But if each monthly payment with interest (~$200) that you pay during that 5 years is allowed to start growing then that changes everything. Now at the end of 30 years you would actually be ahead $5K not behind $15K.

Do you know how it works? Does each payment become eligible to grow as you pay it or does the entire balance have to be paid off before any of it can grow?

Paul said...

your account is growing with the interest you repay yourself and as each months P&I is put back into your account you can direct it into any investment you want

neuroninc said...

I think this guymade financial sense. If he did borrow to invest, that is a good debt. Although you loose a couple of thousand at theend of 30 years, you will make $100,000 or more in monthly income generated every month and probably another 80,000 in possible capital gains after 10 years. I think this authors idea makes more sense. And we should encourage people like him to boost the economy.


Mark Cabigon

Gregory said...

I think the real questions you have to ask yourself is whether you could make more money with your 401k than you would be paying in interest to a bank for your loan. Can you borrow this money in another fashion?

If you could borrow money at 6% interest (likely?) and you could make over 6% interest on your 401k (I am at 10.2% so far this year) then it is a BAD idea to borrow from your 401k.

The 8% interest you are paying yourself is a non-entity and should not be considered as you could put that amount of money in your 401k ANYWAY. The only thing the interest on your 401k loan is doing is forcing you to invest extra money in your 401k. Once again, something you could do anyhow.
The double taxation should not be ignored as interest on most home equity loans would be tax deductible. Interest on your 401k loan is not.

I think now is the most important time to remain in your 401k as taking money out is much the same as selling stock. I think we are all wary of the stock market, but it looks like we are already seeing a bounce back.

Mike said...

I recently changed my company of 10years. If I want to borrow against my 401(k)(from my previous company) - what options do I have?
Will rolling over my 401(K) to an IRA do the trick? Will I be able to borrow against my IRA? Any sugesstion will be greatly appreciated.

Paul said...

Borrowing plans are usually set a the discretion of the employer. If the old plan has that option you might be able to do it.

If you roll over you plan to an IRA, I suggest a self-directed IRA since it will give you the most options

Eric Inscoe said...

I couldn't find this (but the comment list is really long). How about borrowing from 401K for short-term real estate investments such as flipping a house. Done correctly a profit of $20,000 can be made in 6 months. I've looked at hard money loans and they are around 15% APR. For me, I don't have the cash on hand to manage the upfront expense.

Paul said...

Yup, I've done this

anon said...

On a 401K loan for a an investment property is the interest expense deductible against the rental income? I understand the interest expense is not deductible on a personal residence.

Jakec202 said...

I have a question similar to what is being discussed however it involves paying my house off with my 401k loan rather then making a purchase on a new home. I am just looking for some input to see if anyone else sees this as a good idea. By taking a loan out of my 401k with 5% interest I will be able to pay off the balance due on my mortgage which is 5.6%. I will be able to repay the 401k loan provided there are no unforeseen circumstances at work. On the surface this seems like a great idea, I'll have a lower interest rate to pay on the loan and the interest will be going back into my 401k instead of my mortgage lender. Any thoughts?