Author Topic: Borrowing from 401k to pay debt?  (Read 5589 times)

WestchesterFrugal

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Borrowing from 401k to pay debt?
« on: March 16, 2014, 10:53:09 AM »
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« Last Edit: March 23, 2014, 09:14:01 AM by WestchesterFrugal »

saveriam

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Re: Borrowing from 401k to pay debt?
« Reply #1 on: March 16, 2014, 11:16:05 AM »
I have the same thinking as you. 

Free_at_50

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Re: Borrowing from 401k to pay debt?
« Reply #2 on: March 16, 2014, 11:27:11 AM »
Your mortage rate is not your effective rate though for taxes which I assume at your level would put it closer to 3%.  Also the monies in your 401k grows tax defered so I would focus on getting it reinvested so it grows.  I personally have never taken a loan from my 401 and wouldn't unless it was an emergency.

matchewed

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Re: Borrowing from 401k to pay debt?
« Reply #3 on: March 16, 2014, 11:54:32 AM »
Generally considered a bad idea. It's bad for your 401k growth and it has a risk that if you lose employment you'll have to pay off that balance rather quickly (it's actually very ill defined how quickly). Why the urgency to pay off the mortgage? 4.625% is still relatively low, is that .425% difference really eating at your cash flow? If it is you may need to look elsewhere than taking loans out for a solution.

matchewed

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Re: Borrowing from 401k to pay debt?
« Reply #4 on: March 16, 2014, 12:53:38 PM »
Generally considered a bad idea. It's bad for your 401k growth and it has a risk that if you lose employment you'll have to pay off that balance rather quickly (it's actually very ill defined how quickly). Why the urgency to pay off the mortgage? 4.625% is still relatively low, is that .425% difference really eating at your cash flow? If it is you may need to look elsewhere than taking loans out for a solution.
Thanks for the comment

The 401k is in money mkt anyway (tactical asset allocation decision) so we wouldn't be missing out on any growth.  The one consideration would be inability to take advantage of a market crash.

The 4.625% mortgage is fully amortizing, and the monthly payment would decrease with a reduction of principal, so the actual cashflow for us would be worse, but we would be saving the spread as well as paying ourselves the interest.

Additionally we have more than the deductible allowable $1mm of mortgage balance so the effective rate is very close to the mortgage amount.

So if the goal is, for all intents and purposes, to get a better return by paying your mortgage off to get a 4.625% return then why don't you have your 401k in something with more risk? It won't guarantee a return but nothing is guaranteed in this world.

What I mean by cashflow is after you have the mortgage paid off then your cashflow would be better as now you're paying a 4.25% interest rather than a 4.625%. Otherwise where is the advantage in paying off your mortgage with a loan?

And other than that... refi?

Free_at_50

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Re: Borrowing from 401k to pay debt?
« Reply #5 on: March 16, 2014, 02:46:38 PM »
Curious as I also hold an opportunistic cash amount but not in a tax defered account.  What is your strategy benefit using your 401k?  Also didn't realize you were talking about your rental.  I believe you mentioned you were breaking even now.  If you pay down the mortgage do you change your tax situation to the point it costs you on that end?

Weedy Acres

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Re: Borrowing from 401k to pay debt?
« Reply #6 on: March 16, 2014, 04:25:52 PM »
As a way to balance the liquidity risk, what about borrowing a year's worth of payments from the 401(k) and paying them back in 12 months.  Then borrow another year's worth, etc.  That way you'd maintain opportunistic liquidity to buy on a dip, but capture the interest income that you'd otherwise not have with your second choice, a money market fund.

Of course, the other option is to use your excess monthly cash that would otherwise go into taxable accounts and divert it to paying down the mortgage instead.

Mister Fancypants

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Re: Borrowing from 401k to pay debt?
« Reply #7 on: March 16, 2014, 07:47:21 PM »
The general downside of borrowing from a 401(k) is when you have an outstanding loan you are no longer able to make contributions until the loan is paid back losing the tax deferred benefit of the account at your top tax bracket plus state a d FICA.

So the lose of current contributions offsets the savings and complicates your calculations a bit because you would be borrowing up to 50% of your account value but losing your $17.5k contribution plus the company match until the loan is repaid. So for such small margin it may not be worth it.

I would look at the index options in your 401(k) for better returns and you shift investments quickly if buying opportunities arise.

-Mister FancyPants

Mister Fancypants

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Re: Borrowing from 401k to pay debt?
« Reply #8 on: March 17, 2014, 04:29:46 AM »
The general downside of borrowing from a 401(k) is when you have an outstanding loan you are no longer able to make contributions until the loan is paid back losing the tax deferred benefit of the account at your top tax bracket plus state a d FICA.

So the lose of current contributions offsets the savings and complicates your calculations a bit because you would be borrowing up to 50% of your account value but losing your $17.5k contribution plus the company match until the loan is repaid. So for such small margin it may not be worth it.

I would look at the index options in your 401(k) for better returns and you shift investments quickly if buying opportunities arise.

-Mister FancyPants
I was not aware of inability to contribute with an outstanding balance - makes it not worth it then thanks

Confirm with your plan, every company is different, but most don't allow contributions while you have a loan. Follows the reasoning how can you afford to contribute if you needed to borrow from a retirement account. Clearly in your case you didn't need to, it was more about opportunity but the rules are written to address the most common cases of why someone is going to borrow.

warfreak2

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Re: Borrowing from 401k to pay debt?
« Reply #9 on: March 17, 2014, 05:14:46 AM »
A related question: would it make sense to borrow from 401k at 4.25% in above scenario and pay down a 4.00% HELOC, which would maximize flexibility and cashflow?
I don't see how this could ever make sense, unless your cashflow is currently negative. If paying down the HELOC is a priority for you, and you shifted it to your 401k at a higher interest rate, then paying that down would be a priority instead. So, increasing your cashflow (the minimum payment is lower, I guess?) doesn't matter because you shouldn't be paying just the minimum.

Cheddar Stacker

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Re: Borrowing from 401k to pay debt?
« Reply #10 on: March 17, 2014, 06:48:41 AM »
Given all the facts you presented I think it makes some sense for you unless as Mister Fancypants mentioned you can no longer contribute to the plan. I've taken a 401K loan for an investment opportunity as it was the simplest place at the time, and for all the reasons you mentioned above. It worked out very well for me, and I was able to keep contributing to the plan while paying off the loan. It sort of acts like a bond in your portfolio.

If you care to ignore the opportunity cost of not investing in stocks (as you already have) then it can absolutely makes sense to take a 4.25% 401K loan to pay off a 4% heloc. The reason is you are paying the interest to yourself. Obviously it hurts cash flow, but if you don't have to worry about that it's worth considering.

Disclaimer - 401k loans are a tool, but should only be used by people who know what they're getting into, and who do it for the correct reasons.

warfreak2

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Re: Borrowing from 401k to pay debt?
« Reply #11 on: March 17, 2014, 06:57:59 AM »
The reason is you are paying the interest to yourself.
Oh, there's an important detail that I missed, then.

Quote
Obviously it hurts cash flow
Wait, but one of the stated objectives was to maximise cash flow. I think it's not just me who is missing something!

Cheddar Stacker

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Re: Borrowing from 401k to pay debt?
« Reply #12 on: March 17, 2014, 08:41:01 AM »
Obviously it hurts cash flow
Wait, but one of the stated objectives was to maximise cash flow. I think it's not just me who is missing something!

Typically mortgage amortization is very long term, and 401K loan amortization is shorter since you want to get it repaid quickly. Reasons being: 1) If you lose your job you have to pay it back or cash it out with penalty/tax 2) It might limit your contributions to the plan 3) You might want to put your funds back into stocks. If you have the ability to amortize the repayment beyond 5 years and it makes sense to do so it might be cash flow even.

However, the reason for my comment was the increased interest rate. With a higher interest rate, all else being equal, the payment will be higher thus reducing cash flow.

Mister Fancypants

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Re: Borrowing from 401k to pay debt?
« Reply #13 on: March 17, 2014, 08:41:55 AM »
This is a controversial topic and I am not suggested that this is for everyone, I do not do this myself, however it might be a good strategy for one of you, so I am putting it out there and you can decide for yourself if this is something you might be interested in.


To make this work there are a certain set of conditions that need to be in place, the first one is the ability to take a loan from your 401(k), the rate should be about Prime + 1% which is currently 4.25%, this is fairly standard, next is the ability to have a loan and still contribute to the plan. If you cannot do both at the same time then stop right here, giving up the ability to contribute is irrevocable, any year you don't contribute is a lost year, and you never get it back.


You can borrow up to 50% of the vested account value and the interest you pay back is paid to your account, so how does this work, our assumptions are you can contribute while borrowing, I will use 2013 for calculations as we have a full years’ worth of data. You vested account balance is $20k on 1/2/2013 and the only investment option in your 401k is VFORX which is the Vanguard Target Retirement 2040 Fund. If you invest the full $20k in your 401k in VFORX on 1/2/2013 you will buy 844.59 shares @ 23.68. On 12/26/2013 you will receive a .507 dividend for $428.21 which we will reinvest @ $28.15 for an additional 15.21 shares bringing out total to 859.8 which on 12/31/2013 is worth $24,349.54 (28.32 per share) a 21.75% return.


Now if you were to borrow $10k, and invest it in a taxable account the math would work like this. We will keep the investment simple for the example you can obviously make this as complex as you would like. On 1/2/2013 we buy in 401(k) 422.30 shares, on 12/26/2013 reinvest $214.11 for a 7.61 shares for a total of 429.91 worth $12,175.05 on 12/31/2013. Now the borrowed $10k is used to buy SPY which is a low cost ETF that tracks the S&P 500, buying 68.47 shares @ $146.06. On 3/15/2013 a dividend of $47.52 is paid and reinvested to buy an additional .3 share bringing the total to 68.5. On 6/21/2013 the next dividend of $57.47 reinvested buying another additional .36 shares bringing the total to 68.86 shares. On 9/2/2013 the next dividend of $57.70 reinvested buying another additional .33 shares bringing the total to 69.19 shares.
On 12/20/2013 the next dividend of $67.81 reinvested buying another additional .37 shares bringing the total to 69.56 shares. On 12/31/2013 the total value at shares price $184.69 will be $12,847. Now we have to pay the $425 in interest on the initial loan, so this account value is $12,422 after the interest is repaid plus the $12,175 for total account value of $24,597. You wind up with a final account value of $248 more or a 22.99% return. An extra 1.25% this may not be worth it, for some, for others it might be.


Now there are few holes in this for starters I have not accounted for taxes, based on the sale dates it would be short term capital gains, so at the bare minimum I would wait a few extra days, taxes complicate this a lot as everyone has a unique tax situation so you need to do your own math there. Also you don't have to pay sell the amount that is profit that can be left in the taxable account, so there is flexibility with what to do with the funds. I also used a simple investment example, based on your 401(k) options you might have much worse options in your 401(k) which makes this much more lucrative. Also I simple used SPY outside the 401(k) which is highly risky outside the 401(k) where a more diversified portfolio could provide different results. There is also like in any strategy a risk it could go there other way and you lose more than you would gain so you need to evaluate the strategy and risk aversion to see if this is something you would be interested in doing.


Now before the Face Punches come, I am not suggesting this I am putting the information out there so people can be aware, I do not do this as my current 401k allows for any mutual fund to be purchased in a linked brokerage account, so I manage my vested 401k balance with my other retirement accounts and use a mutual fund the meets my asset allocation needs. Any time you switch jobs I suggest rolling your 401k into an IRA so you can have complete control of your investments.

-Mister FancyPants

ZiziPB

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Re: Borrowing from 401k to pay debt?
« Reply #14 on: March 17, 2014, 10:09:15 AM »
Quote
We may try it with a small amount if taking the loan doesn't prevent us from contributing to the plan

But even if it does our 401k is usually topped off early in the year from the cash portion of our bonus, so could theoretically take the loan after it is maxed every January then repay the loan right before the next year's bonus is paid

Keep in mind that the max amount permitted to be borrowed is $50K (it's actually the lesser of $50K and 50% of your account balance) and it must be repaid in substantially equal periodic payments (per IRS). 

Cheddar Stacker

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Re: Borrowing from 401k to pay debt?
« Reply #15 on: March 17, 2014, 12:46:41 PM »
I setup my repayment terms for 24 months, equal payments. Then I received a bonus and paid it off early by sending a check to the TPA. You can pay it off early unless your plan has some strange rule within it precluding you from doing so.