Dear Dollar Stretcher,
We’re going to buy a newer car. We’ll need to borrow about $12,000 to pay for it. Our friends have suggested that the best way to finance it is by ‘borrowing’ from our 401k plan at work. They say that the rate’s cheaper than what we would pay somewhere else and that way we’d be paying ourselves the interest. That sounds too easy. What’s the catch?
Lucy isn’t alone in wondering about 401k loans. Pension plan experts say that 90% of the plans allow for loans. It’s estimated that about 20% of 401k participants are paying back a loan. She’s also not alone in feeling confused in trying to decide if a 401k loan is a good idea.
What’s the best way to compare this loan to borrowing from somewhere else? The first thing that most people do is to compare the interest charged on the loan. The rate is set by the plan administrator. The law says that it needs to be a ‘reasonable’ rate. For our illustration let’s say that the rate is 2% less than the rate that Lucy’s dealer would charge. Good deal, right?
Not so fast, my spendthrift friend. Let’s think about this. When you’re a borrower you want lower rates. But when you’re the lender you want higher rates. This time you’re both. So we’re back to our original question. Is this a good deal or not?
We still need another estimate to complete our analysis. We need to know how much we expect our money to earn in the 401k plan if we don’t borrow the money. This isn’t likely to be an easy or precise estimate to get, either. The earnings will depend on how the money is invested. And each plan has different investment options available. Some are very conservative and only offer guaranteed type investments with a lower rate of interest. Other plans are heavily invested in the stock of your employer. Depending on the performance of that stock, your return can be terrific or terrible. And don’t expect your employer to give you an estimate of what the return will be. Way too much legal risk for that to happen.
Ultimately, you’ll probably have to take a look at what’s happened in past years, take a guess about the future and go with your instincts. Let’s suppose that you think that the earnings will be about 3% higher than the loan interest rate. So how’s that important?
That 3% lower earning means that we’ll have fewer dollars in the 401k plan at retirement. You can estimate how much it will be, if you want to. Suppose your loan, like Lucy’s, was $12,000 and you expected to pay it back in 5 years. By borrowing the money yourself, you’ll earn 3% less on that $12,000 or $360. Next year you’ll have some of the principal paid back so the difference will be less. If you multiply the $360 by half the length of the loan you’ll be about right. In this case that’s 2.5 x $360 or $900. So when the loan is paid back your 401k account will be $900 smaller than if you didn’t take out the loan. So what?
Well, that $900 will grow before you retire. There’s an easy way to estimate what it will be worth at retirement. If the money earns 9% it will double every eight years. So if you’re eight years from retirement, you will have $1800 less (2 x $900). If you’re 16 years from retirement, it will double again. We don’t know how old Lucy is. But she can figure out how many years she has until retirement and then double the lost earnings for every eight year period until she reaches retirement.
If this is hard to picture, just take a piece of paper and make two columns. In the first column mark down your age, your age + 8 years, + 8 more years, etc. For instance, if Lucy were 45, her’s would read, 45, 53, 61 and 69. In the second column list the lost earnings next to your age. Then double it for every age you have listed. It would be $900, $1800, $3600 and $7200.
At retirement, Lucy would take between 5% and 10% of the $7200 annually. So her decision today could cost her between $360 and $720 each year during her retirement.
How does that compare to the lower car payments today? We said that she’d be saving about 2% on the $12,000 loan. She’ll probably save about $200 per year.
Now Lucy has a framework to make a decision. She can save a little in interest now, but the price is a lower income at retirement. In some cases, you may find that the interest you’d pay on the 401k loan is greater than the rate of earnings you expect. Then you’d have more money in the account at retirement if you took the loan.
There are a couple of other things that Lucy needs to know about 401k loans before she drives off in that new car. The law specifies that the loan be repaid in less than five years or when the 401k account is closed. One exception is that loans for a primary residence can be repaid over 30 years.
This requirement can have important consequences. If you leave your job, you can expect to close your 401k plan. That means that you need to repay any loan balance. You might have to turn down a job offer with a different company because you can’t repay the 401k loan. Worse yet, you might have the whole loan due just when you’ve lost your job to downsizing. Talk about bad timing!
You do have the option of not paying it back. After all, it is your money. But the consequences are pretty ugly. First, you’ll pay a 10% early withdrawal penalty. Then add ordinary income taxes on the ‘distribution’. In Lucy’s case, if she had $10,000 left and had to default, it would cost her $3800 if she were in the 28% tax bracket.
Depending on your circumstances, a 401k loan could be a blessing or a belated curse. Many financial planners urge you to consider all the options before using them. Thanks to Lucy for asking a good question. Let’s hope she enjoys that new car!