Author Topic: 401k loan vs cash for one time larger purchase  (Read 827 times)

bigblock440

  • 5 O'Clock Shadow
  • *
  • Posts: 88
401k loan vs cash for one time larger purchase
« on: February 12, 2020, 01:57:19 PM »
Hi, I searched through the forums and didn't really find anything useful on this topic, but how bad of an idea is a 401k loan really?  It seems like it could be advantageous under certain circumstances.

The specific scenario I'm thinking of would be taking out a small 401k loan for a one time purchase, say 3-5k, for something like a car or other large appliance/improvement project etc. that would be purchased anyway but would otherwise have to be saved up for (did initially think of a student loan I had, but thanks forum search for reminding me of the tax deductible interest would need to be factored in).  Assuming there's still quite a bit of room to max the 401k, would it make more sense to save up for that purchase keeping the cash out of the market until you were ready to buy, or to plow as much as you can into the 401k and taking the loan when you were ready to buy?  The way I see it, the cash will be out of the market anyway, so that argument's moot, and it would be no different than lowering contributions that some have suggested.  Paying interest back to yourself seems like it'd be more advantageous than to a bank, and 5% is about as good as you'd get anywhere.  The smaller amount and 6-12 month payback period would mitigate the job loss risk.  What are the downsides that I'm missing?  Obviously not something you'd want to get in the habit of doing though.

Dicey

  • Senior Mustachian
  • ********
  • Posts: 12761
  • Age: 62
  • Location: NorCal
Re: 401k loan vs cash for one time larger purchase
« Reply #1 on: February 12, 2020, 02:06:39 PM »
You are considering taking out a loan for something that's not a hair-on-fire emergency. How do you think this forum is going to react?

This topic was also discussed extensively several years ago on a thread about your worst money mistake, but this one will get you started.

This thread below is old, but it was a five-second google search. Your future sell will thank you for studying up on this question. However, if you're feeling lazy, the short answer is, under the circumstances you're proposing, HELL NO!

https://forum.mrmoneymustache.com/ask-a-mustachian/taking-401k-loan/

RWD

  • Magnum Stache
  • ******
  • Posts: 4013
  • Location: Mississippi
Re: 401k loan vs cash for one time larger purchase
« Reply #2 on: February 12, 2020, 02:40:09 PM »
The specific scenario I'm thinking of would be taking out a small 401k loan for a one time purchase, say 3-5k, for something like a car

You know car loans exist, right? I just got an $11k loan at 1.49% and my money can stay invested.

bigblock440

  • 5 O'Clock Shadow
  • *
  • Posts: 88
Re: 401k loan vs cash for one time larger purchase
« Reply #3 on: February 12, 2020, 02:51:21 PM »
I found that one, but it wasn't really helpful (aside from eliminating the student loan thing as a reason).  I was hoping for something more substantial like the DPOYM or stop worrying about the 4% rule, I couldn't find any good arguments for or against the 401k loan. Why specifically would saving in cash be better than putting more into the 401k?  I'd think the closer you could get to max the 401k, the better, and holding cash doesn't help much there.  Or to put another way, why would putting your deferred spending into a savings account be better than keeping it in the market until it may be needed? 


For reference, I'm fairly early in the accumulation phase and have at least 10 years out before I'm anywhere near FI and only somewhat recently discovered it was possible to RE.  Still trying to fine-tune my strategy, and realistically the 3-5k won't make much difference one way or the other, so it seemed like a possibly more effective strategy. 

bigblock440

  • 5 O'Clock Shadow
  • *
  • Posts: 88
Re: 401k loan vs cash for one time larger purchase
« Reply #4 on: February 12, 2020, 02:58:45 PM »
The specific scenario I'm thinking of would be taking out a small 401k loan for a one time purchase, say 3-5k, for something like a car

You know car loans exist, right? I just got an $11k loan at 1.49% and my money can stay invested.

Nobody's going to give a loan for the cars I'm going to be purchasing (when your searching for a parts car and all of the $500 examples are lower mileage and better shape than your current car, you're probably in beater status).  And a car was just one potential use.  Another I had in mind was a deal on an old tractor/backhoe that I intend to buy in the near future (year or two), but don't necessarily need right this minute thanks to a mild winter and not needing to deal with too much snow and building projects not finalized yet.  Another example could be replacing a roof, insulating, installing a heat pump, etc.  Why would saving for those things in cash be better than putting as much as possible into the 401k, then taking a small, short-term loan if/when the time comes?
« Last Edit: February 12, 2020, 03:00:56 PM by bigblock440 »

dandarc

  • Magnum Stache
  • ******
  • Posts: 3966
  • Age: 37
Re: 401k loan vs cash for one time larger purchase
« Reply #5 on: February 12, 2020, 03:00:39 PM »
So now the question is not "take out a 401K loan" but 401K vs. a savings account? Nobody said funding a cash savings account was better than funding your 401K. They said "don't take out a 401K loan". Reasons for that being the usual advice are myriad - there is the risk component in that if you get fired you also typically have to pay the loan back in short order. You unplug the investments to take out the loan. You say "but I'm paying the 3% interest to myself!" and I say "sure, but you're losing the 10% expected return on that money".

Also this is just ridiculous:
Quote
For reference, I'm fairly early in the accumulation phase and have at least 10 years out before I'm anywhere near FI and only somewhat recently discovered it was possible to RE.  Still trying to fine-tune my strategy, and realistically the 3-5k won't make much difference one way or the other, so it seemed like a possibly more effective strategy.

3-5K decisions will never matter more than when you're just starting out.

DeniseNJ

  • Bristles
  • ***
  • Posts: 359
Re: 401k loan vs cash for one time larger purchase
« Reply #6 on: February 12, 2020, 03:01:01 PM »
Quote
Why specifically would saving in cash be better than putting more into the 401k?  I'd think the closer you could get to max the 401k, the better, and holding cash doesn't help much there.  Or to put another way, why would putting your deferred spending into a savings account be better than keeping it in the market until it may be needed?

Well, it would reduce your tax liability to max your 401K and take a loan from it rather than not max it and pay for something out of pocket.  It is also better to pay yourself interest than to pay others, although you have to consider the loss of not being in the market when you compare the true cost of borrowing.

However, leaving it in your 401K until needed is a horrible idea bc when you need it you may have to sell at a loss.  Money that you NEED should not be in the market at all.  That's why emergency funds are not in the market.  Also, you may be limited in the number of 401K loans or the amounts or the frequency you can take a loan so if you do need a loan later on you won't have it available.

Bottom line, save for something you want or do without it.  If you aren't maxing your 401K, do you really need a stove you have to take out a loan to buy?  If you need a car NOW then fine take out as little as possible and buy a cheap car.  But if you have time to plan, then you have time to save.


Boofinator

  • Handlebar Stache
  • *****
  • Posts: 1437
Re: 401k loan vs cash for one time larger purchase
« Reply #8 on: February 12, 2020, 04:03:11 PM »
What's your tax bracket?

Regardless, if you are not currently maxing out your 401k, I recommend putting as much money as you can into the 401k and then take out a loan from there if needed (though if you can find a loan with an incredibly low interest rate, like <3%, you might want to go with that instead). 401k loans are a good thing, if they mean you can increase your contributions to the 401k.

Goldy

  • Bristles
  • ***
  • Posts: 262
Re: 401k loan vs cash for one time larger purchase
« Reply #9 on: February 12, 2020, 05:23:51 PM »
The specific scenario I'm thinking of would be taking out a small 401k loan for a one time purchase, say 3-5k, for something like a car

You know car loans exist, right? I just got an $11k loan at 1.49% and my money can stay invested.

Where did you find that?

RWD

  • Magnum Stache
  • ******
  • Posts: 4013
  • Location: Mississippi
Re: 401k loan vs cash for one time larger purchase
« Reply #10 on: February 12, 2020, 07:10:37 PM »
The specific scenario I'm thinking of would be taking out a small 401k loan for a one time purchase, say 3-5k, for something like a car

You know car loans exist, right? I just got an $11k loan at 1.49% and my money can stay invested.

Where did you find that?

My local credit union. It's a 24 month loan.

bigblock440

  • 5 O'Clock Shadow
  • *
  • Posts: 88
Re: 401k loan vs cash for one time larger purchase
« Reply #11 on: February 12, 2020, 09:14:25 PM »
I couldn't find any good arguments for or against the 401k loan.

Have you read the other forum threads on this topic?
https://forum.mrmoneymustache.com/welcome-to-the-forum/401k-loans/
https://forum.mrmoneymustache.com/investor-alley/401k-loan-taboo/
https://forum.mrmoneymustache.com/ask-a-mustachian/pay-off-401k-loan/
https://forum.mrmoneymustache.com/taxes/penalty-from-not-repaying-401k-loan/
https://forum.mrmoneymustache.com/ask-a-mustachian/401k-loan-for-down-payment/
https://forum.mrmoneymustache.com/investor-alley/the-exact-math-behind-using-401k-loan-to-pay-down-debt/
https://forum.mrmoneymustache.com/ask-a-mustachian/taking-401k-loan/
etc.

For a specific scenario it's pretty easy to run some numbers in a spreadsheet to see what is the best course of action given your assumptions, tax bracket, length of loan, etc.

Thanks, I used the sites search box, but did not use google.  Read the a random selection, but didn't seem to find anything better than "don't do it" with any real reasoning.  I'll read through those first.

bigblock440

  • 5 O'Clock Shadow
  • *
  • Posts: 88
Re: 401k loan vs cash for one time larger purchase
« Reply #12 on: February 12, 2020, 09:36:37 PM »
So now the question is not "take out a 401K loan" but 401K vs. a savings account? Nobody said funding a cash savings account was better than funding your 401K. They said "don't take out a 401K loan". Reasons for that being the usual advice are myriad - there is the risk component in that if you get fired you also typically have to pay the loan back in short order.


Yes, the question I'm asking is 401k vs savings, sure there are risks to needing to take the loan in a downturn, but I've got credit cards and a Roth (can't retroactively contribute to a 401k) if I have a true emergency.  I understand the having to pay it back or having to pay it back within the year of your termination or having to pay the 10% early withdrawal tax, I just don't know what I might be missing that make people say it's such a bad idea.

Quote
You unplug the investments to take out the loan. You say "but I'm paying the 3% interest to myself!" and I say "sure, but you're losing the 10% expected return on that money".

Right, but you'd be losing the 10% expected return if you never put it in as well.  I've got to read through the links RWD posted, see if there's anything in there that I'm missing or if it really is as straightforward as it seems.

Quote
Also this is just ridiculous:
Quote
For reference, I'm fairly early in the accumulation phase and have at least 10 years out before I'm anywhere near FI and only somewhat recently discovered it was possible to RE.  Still trying to fine-tune my strategy, and realistically the 3-5k won't make much difference one way or the other, so it seemed like a possibly more effective strategy.

3-5K decisions will never matter more than when you're just starting out.

Kinda why I'm asking, I'm not necessarily just starting out, but still fairly early due to not even realizing it was an option to not work into your 60's.  (30yo, NW ~140k including real estate, 55k 401k, ~13k in vanguard taxable)  I wasn't looking for a case study (read enough of them), but looking for reasons why one may be preferable to the other.  Thanks for the input.

RWD

  • Magnum Stache
  • ******
  • Posts: 4013
  • Location: Mississippi
Re: 401k loan vs cash for one time larger purchase
« Reply #13 on: February 13, 2020, 07:18:52 AM »
Read the a random selection, but didn't seem to find anything better than "don't do it" with any real reasoning.

Some potential pitfalls (may depend on your company's plan):
- You may not be allowed to contribute to your 401k while paying back a loan from it
- If you leave the company you may be required to pay the balance faster or immediately
- If you default the remaining principal on the loan becomes a taxable withdrawal, possibly with penalties
Additional reading: https://www.investopedia.com/articles/retirement/06/eightreasons401k.asp

A 401k loan is a tool, not inherently good or bad. It's usually the wrong tool but as I stated before you can run some numbers in a spreadsheet to calculate the expected difference between that and saving in cash (or other options). I'd be happy to run a scenario for you if you're interested, would just need your assumptions (amount available to contribute, marginal tax rate, loan amount, interest rate, assumed investment performance).

FatFI2025

  • Bristles
  • ***
  • Posts: 318
  • Location: California
Re: 401k loan vs cash for one time larger purchase
« Reply #14 on: February 14, 2020, 08:19:22 AM »
A 401k loan is a tool, not inherently good or bad. It's usually the wrong tool but as I stated before you can run some numbers in a spreadsheet to calculate the expected difference between that and saving in cash (or other options).

+1 I don't think 401K loans are a forbidden financial tool and depending on how you run the analysis, it could come out better than using after tax savings.

But I think that use of a 401K loan for a $5K purchase indicates a liquidity strategy that's too lean. An individual should have different pockets to pull from -- taxable, Roth, tax-deferred -- to maximize efficiency over the long run, including dealing with unexpected liquidity demands. You might get better overall returns by maxing out a 401K and having little after-tax savings over a long period of time, but that reward comes with higher risk. As others have said, if you take out the loan then get terminated, that 10% penalty plus highest bracket taxation (or having to roll it to a CC) will erase all benefits from the strategy and then some.

For people with decent credit and income there are just way better options out there than a 401K loan.

RWD

  • Magnum Stache
  • ******
  • Posts: 4013
  • Location: Mississippi
Re: 401k loan vs cash for one time larger purchase
« Reply #15 on: February 14, 2020, 08:44:54 AM »
But I think that use of a 401K loan for a $5K purchase indicates a liquidity strategy that's too lean.

Agreed. This amount should be easily absorbed by an emergency fund.