Author Topic: 401k loan taboo  (Read 5634 times)

BeardedMustache

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401k loan taboo
« on: December 21, 2016, 08:46:12 AM »
Hey forum,

I've spent a good deal of time considering the following strategy and I believe Iíve got it worked out. However, a second (or more) set of eyes looking at the idea never hurts.

The general consensus is that 401k loans are the devil, and for the gen pop I agree, especially if itís to be used for a vacation, jet ski, clown college, etc. In this case, Iíd be looking to pay off private student loan debt at a 6.5% rate with a loan to myself at 4.5%.

Letís look at the details:
-Current loan - $50k, 6.5%, 15 years, Total interest paid over life of loan = $28,400
-401k loan - $50k, 4.5%, 5 years: Total interest paid over life of loan = $5,929

Considerations:
-Taxes: no change, all after tax $
-Investment: assume that this was all to be invested in bond funds
-Job loss: low risk
-Cash flow: I can make the payments

So, there it is. I welcome any discussion on the topic, and I really am open to comments/critique.

Thanks for reading!

NoStacheOhio

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Re: 401k loan taboo
« Reply #1 on: December 21, 2016, 10:00:28 AM »
What's your current 401k balance?

Spork

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Re: 401k loan taboo
« Reply #2 on: December 21, 2016, 10:06:11 AM »
(Warning: I haven't done the math.  It might still work out in the 401k's favor.)

I think you have underestimated the costs of the 401k loan.  In addition to the 4.5% interest, you need to account for the compounding returns on the $50k that you are not getting.  And you need to account for it in perpetuity... because even after you've paid back the loan, you haven't paid back the missing compounding.

therethere

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Re: 401k loan taboo
« Reply #3 on: December 21, 2016, 10:17:04 AM »
Some 401k loans the interest is paid to your 401k account. That's a detail you should look into.  Also, you should be comparing the loans with the same payback period. I.e. interest paid on the student loan over 5 years, not 15. Most companies only let you take a loan on 50% of the balance. And you need to pay back immediately in the case of job loss or layoff.

This is not a math question. 5% is always going to be lower total interest than 6.5% loan on the same terms. This is a flexibility, risk, and comfort factor decision.


Here's an intangible factor.... Do you anticipate your life expenses going up within 5 years that committing to pay 1k/month back to a 401k loan is no issue? It is one thing to pay 1k in payments monthly, its another thing to have the agreed upon monthly payment at 1k. Mainly I'm thinking kids and a drop to one income, buying a house and needing a certain PITI, etc. Also, do you plan to stay at your job for 5 years? That's a long time now a days. The going cycle rate at my work seems to be 1.5-3 years before people are looking into new jobs for growth.
« Last Edit: December 21, 2016, 10:20:21 AM by therethere »

BlueHouse

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Re: 401k loan taboo
« Reply #4 on: December 21, 2016, 10:18:29 AM »
Here's a calculator to help you determine how much you'll lose out on for that compouning that Spork referred to

http://www.bankrate.com/calculators/retirement/borrow-from-401k-calculator.aspx

I vote a strong no.  You may have to work longer than you calculated to make the payments because you're paying back with after-tax dollars. 

Have you looked into refinancing the student loans or getting a personal loan?  How much will you save if you simply accelerate your payments to your student loans by paying them off in 5 years vs. 15?   

BeardedMustache

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Re: 401k loan taboo
« Reply #5 on: December 21, 2016, 10:40:03 AM »
First off, thanks for the great responses!

Regarding compounding, would this be any different than investing in a bond at a 4.5% rate? Additionally, assuming that I use the difference in interest paid productively (invested, not spent), that amount would be compounded as well.

Regarding after tax dollars, the student loan payment is also made after tax.




BeardedMustache

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Re: 401k loan taboo
« Reply #6 on: December 21, 2016, 10:41:20 AM »
Forgot to mention also, the 4.5% interest goes back to my 401k account

kendallf

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Re: 401k loan taboo
« Reply #7 on: December 21, 2016, 10:41:36 AM »
I vote no as well.  You say "assume the 401k is invested in bonds", to which I say, why?  If you're young and just starting your career (my assumption), your 401k should not have a heavy bond percentage. 

If you repaid your current loan in 5 years, you'd pay $8700 in interest.  The lost investment return and compounding of that return over those 5 years is likely more than this, especially if it's invested in a diverse stock portfolio.  I wouldn't compare it to the "interest paid" on a 401k loan, as that is really just forced after tax savings (i.e., the interest is going into your account).

Spork

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Re: 401k loan taboo
« Reply #8 on: December 21, 2016, 10:43:00 AM »

This is not a math question. 5% is always going to be lower total interest than 6.5% loan on the same terms. This is a flexibility, risk, and comfort factor decision.


It's not the same terms.

$50k borrowed from a bank... The bank is missing out on investment income, so it costs more.  (YOU are the investment income.)
$50k borrowed from yourself... YOU are missing out on the investment income, so you need to account for that.

That doesn't mean the 401k isn't the better deal.  But it means it's not quite 6.5% vs 4.5%.  Take a look at the calculator Bluehouse posted. 

I generally make a spreadsheet that brute forces the calculations over the years when I'm looking at this sort of decision.

BuzzardsBay

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Re: 401k loan taboo
« Reply #9 on: December 21, 2016, 10:55:16 AM »
And what happens when six months into it you lose your job or decide to leave and have to pay the balance in 30 days or it's considered a taxable withdrawal?

BuzzardsBay

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Re: 401k loan taboo
« Reply #10 on: December 21, 2016, 10:59:19 AM »
Letís look at the details:
-Current loan - $50k, 6.5%, 15 years, Total interest paid over life of loan = $28,400
-401k loan - $50k, 4.5%, 5 years: Total interest paid over life of loan = $5,929

Also - why are you looking at paying the original loan off in 15 years?  That's crazy.  Do a budget, throw everything you possibly can at it, and pay it off in 2 years.  Then you won't have to be trying to move loans around to save a point or two on interest.  The problem isn't the rate, it's that fact that want to take so long to pay it off.  Just be done with it and move on.

BeardedMustache

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Re: 401k loan taboo
« Reply #11 on: December 21, 2016, 11:20:54 AM »
Buzzard, that's one way to look at it... and I'm not saying it's wrong.

They way I'm thinking about it is I have an asset and a liability on the balance sheet. If I can use the asset to erase the liability and positively affect the P&L, why wouldn't I at least look at doing that?

The obvious concerns are cash flow and possibility of job loss. I believe these to be minimal. Again though, I haven't decided which way to go but I think it merits discussion.

Spork

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Re: 401k loan taboo
« Reply #12 on: December 21, 2016, 12:04:20 PM »
https://docs.google.com/spreadsheets/d/1acvWE5WC7MPOFmoMgrFLMecXOCZYsJ8EPvZ5WJT7OGg/

Here is my stab at comparison.  BE VERY SKEPTICAL OF MY MATH!

I have made a lot of assumptions, which are 100% guaranteed to be wrong.   I've also been lazy with the spreadsheet formulas.  When the loan balances hit zero, I just pasted 0 in there instead of having a formula testing for zero.

I also am not 100% sure how you compute "net worth" in the instance of the 401k loan.  The liability of $50k on month 1 is a liability to oneself... so I made the assumption that in accounting terms, it was not a liability.  You effectively have a liability of $50k and an asset of a $50k loan owed to oneself, which is net zero.

With my (guaranteed incorrect) assumptions...  The 401k loan is the loser by about $8500.  Incidentally, that's about the number Bluehouse's calculator came up with when I used it.

Edit:
Went grocery shopping and was thinking about this.  What I originally wrote is (I think) incorrect.
The cost of the standard student loan is the sum of the interest: $28,468
The cost of the 401k loan is "lost income when the money wasn't there compounding": $8529  plus
money lost by the fact that you are paying tax sheltered money back with taxed money: $8500
for a total cost of: $17,029

I would say (if you don't somehow include the cost of the risk of losing your job) the 401k loan is cheaper.

I suspect -- and haven't looked at it -- it is cheaper still to just pay the regular student loan off early.  If you can afford to cash flow the 401k loan at $900 a month... you can also afford to throw that much at the standard loan.

Edit again:
Added a 3rd set of columns for cost of standard student loan paid at the same rate the 5 year 401k loan is paid at.
Cost of doing this: $5,930   

This is the clear winner.  (Adjust assumptions to match your own... and for god sakes, check my logic and math!)
« Last Edit: December 21, 2016, 05:56:40 PM by Spork »

bada bing

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Re: 401k loan taboo
« Reply #13 on: December 22, 2016, 10:10:37 AM »
The 4.5% 401k interest paid to oneself is confusing people. That "interest" is
a wash and doesn't matter. What matters mathematically is the 6.5% interest
being paid out while you have available assets (a 401K balance) that could pay
the debt and stop the interest. Basically the question is: are you comfortable paying
6.5% for money to invest in a 401K (in bonds even???) ? I wouldn't borrow money at
6.5% to invest in my 401K even though I expect my 401K to beat that over the long
haul. Especially not at current market valuations (excuse the blatant market timing).

Two confounding factors are the unbankruptable nature of student loans (making it
more valuable to get rid of them) and the risk of job loss making a 401K loan "callable".
The relative value of both those factors is a guess based on individual situation. The
whole decision is a risk/reward calculation where the risk can only be estimated.

There is a human factor as well. If you do the 401k loan, what will you do with the "savings" ?
If you intend to invest it advantageously (like bump up retirement contributions), then it
seems more valuable to me than if you intend to devote the savings to current consumption.

Spork

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Re: 401k loan taboo
« Reply #14 on: December 22, 2016, 10:24:13 AM »
What matters mathematically is the 6.5% interest
being paid out while you have available assets (a 401K balance) that could pay
the debt and stop the interest. Basically the question is: are you comfortable paying
6.5% for money to invest in a 401K (in bonds even???) ? I wouldn't borrow money at
6.5% to invest in my 401K even though I expect my 401K to beat that over the long
haul. Especially not at current market valuations (excuse the blatant market timing).


Look at the spreadsheet above.  It's more than paying debt and stopping the interest.  (Although I do agree that the 4.5% paid to oneself is a red herring.)
1.  It's the lost income/interest/compounding of the 401k that is a real and calculable cost.
2.  It is the fact that you are replacing non-taxed funds with taxed funds that is a real and calculable cost.  (You're effectively paying tax on the $50k twice.  Once on repayment of the loan and a second time when you claim the income at retirement.)

Enigma

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Re: 401k loan taboo
« Reply #15 on: December 22, 2016, 10:33:21 AM »
I don't think you are actually being fair in your assessment.  To be fair if you have a goal of 5 years then both loans need to be forced to 5 years.  IMO you should be more aggressive on paying your student loan debt:

Relook at the details:
-Current loan - $50k, 6.5%, 5 years aggressive pmts, Total interest paid over life of loan = $8.698 (pmt $978)
-401k loan - $50k, 4.5%, 5 years: Total interest paid over life of loan = $5,929 (pmt $932)

I also believe that the current student loan is easier to pay extra principal on rather than a 401k loan that is tied to your work pay.  That much student loan interest may even be tax deductible (Lifelong learning credits, etc)

Enigma

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Re: 401k loan taboo
« Reply #16 on: December 22, 2016, 11:03:57 AM »
What is the total student loan amount that you owe?
- My assumption would be more than 50k.  Which means you will still be making the same student loan pmt > $370/month
- Going your route you will lose $932/month from your paycheck

At the very least your income for the month will be decreased by 1.3k/month until (a) 5 years is & 401k repaid or (b) student loan is paid up...  whichever is sooner.  However, making extra payments of $932/m towards your student loan directly will cut off 50k in 44 months (less than 4 years).

Drifterrider

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Re: 401k loan taboo
« Reply #17 on: December 22, 2016, 11:22:13 AM »

Considerations:
-Taxes: no change, all after tax $

Don't be so sure.  You need to check with your 401K plan.

With mine, I pay my interest back into my account. 

BUT


I am borrowing tax deferred money.  I have to pay it back with taxable money.  I still have to pay taxes on everything when I take withdrawals because it is "tax differed".

So, I pay back with tax paid money and then pay taxes on that when I take it back out.

401K loans are usually the MOST expensive way to borrow.


ender

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Re: 401k loan taboo
« Reply #18 on: December 22, 2016, 11:24:48 AM »
The #1 reason why 401k loans are a bad idea is you are tied towards paying it off within 30 days of leaving your employer.

Unless you are willing to potentially pay $20k worth of taxes if you lose your job (or want a new job) this is a terrible idea.

BeardedMustache

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Re: 401k loan taboo
« Reply #19 on: December 22, 2016, 11:43:11 AM »
Regarding loan payments being taxed twice, here's a relevant article:

https://vanguardblog.com/2009/07/24/401k-loans-are-you-really-taxed-twice/

TLDR: "Yes, youíre using after-tax money to replace your pre-tax money. But you also used pre-tax money to, for example, buy a car, or pay off credit cards, so it all evens out."

BeardedMustache

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Re: 401k loan taboo
« Reply #20 on: December 22, 2016, 12:00:40 PM »
Spork, thanks for all the effort you put into you analysis! I've made a similar excel file based on your model (and "for god sakes" checked the math) :)

In my model, the loss of compounding by taking the loan is negated by the addition of interest. I need to go back and add in tax on the repayments to compare.

Spork

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Re: 401k loan taboo
« Reply #21 on: December 22, 2016, 12:38:32 PM »
Regarding loan payments being taxed twice, here's a relevant article:

https://vanguardblog.com/2009/07/24/401k-loans-are-you-really-taxed-twice/

TLDR: "Yes, youíre using after-tax money to replace your pre-tax money. But you also used pre-tax money to, for example, buy a car, or pay off credit cards, so it all evens out."

Huh.  Yeah, I guess that makes sense.  So strike what I said earlier.  ;)  [Edited spreadsheet to apply the tax "penalty" only to the 401k interest]
« Last Edit: December 22, 2016, 01:55:16 PM by Spork »

Cpa Cat

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Re: 401k loan taboo
« Reply #22 on: December 22, 2016, 12:40:32 PM »
I tried to find some stats on how often 401k loans are defaulted on (due to job change). My own anecdotal experience with clients is that it happens very frequently (50-75% of 401k loans that I've seen) - it's something I noticed when doing 401k audits and now with my own tax clients. This makes intuitive sense, since the average employee stay is 4.4 years (and less for younger workers).

And while a layoff may have, in your assessment, a low probability, there's a pretty significant opportunity cost to you if you avoid looking for new job opportunities for the next five years in order to avoid the 401k loan distribution. The average job-hop involves a pay increase of 10-20%, which you would be foregoing by not allowing yourself to change jobs in the next five years. Not to mention the emotional impact of potentially feeling trapped if circumstances change for you and you want to make a geographic change or you feel less enthused about your current employment situation.

I think it's bad idea to discount the high likelihood of the loan turning into a distribution.

rpr

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Re: 401k loan taboo
« Reply #23 on: December 22, 2016, 01:51:59 PM »
In general, I believe in keeping things simple. The KISS philosophy works wonders.

Here is another way to look at it assuming that you have the cash flow to pay $932/month ($50000 401k loan at 4.5%). If you kept paying back the current loan with the 6.5% interest rate at the $932/month payment, you will need an extra 4 months to pay off when compared to using the 401k at 4.5%.

All of this is a useful learning exercise with the calculations. There are some situations where a 401k loan is a good choice. But IMO, this is not one of those. 

Spork

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Re: 401k loan taboo
« Reply #24 on: December 22, 2016, 01:56:59 PM »
Spork, thanks for all the effort you put into you analysis! I've made a similar excel file based on your model (and "for god sakes" checked the math) :)

In my model, the loss of compounding by taking the loan is negated by the addition of interest. I need to go back and add in tax on the repayments to compare.

This was mostly done as a curiosity on my part to really try to understand which was better (and in what cases).  I still am not 100% sure my logic is correct, but AFAIK it is.

Brilliantine

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Re: 401k loan taboo
« Reply #25 on: December 22, 2016, 02:24:24 PM »
With regards to having the 401k loan called. My anecdotal experience is, Fidelity didn't call for my two loans when I quit my job. Instead of the semi-monthly loan repayment deductions from my paycheck, they printed and sent me monthly coupon payment thingies. I didn't ask for this. In fact I was fully prepared to pay back the loans. They just did it*.

The loan interest that you are paying, you are paying back to yourself. So, I think the only costs associated with 401k loans are the loan administration fees and the opportunity cost.


* My 401k at the new job is also managed by Fidelity but I don't know if this was a factor in their decision. Also, I quit a job at a huge tech company to start a job at a huge tech company. Between the two loans, I owed a total of ~$20K.



Spork

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Re: 401k loan taboo
« Reply #26 on: December 22, 2016, 05:35:06 PM »
With regards to having the 401k loan called. My anecdotal experience is, Fidelity didn't call for my two loans when I quit my job. Instead of the semi-monthly loan repayment deductions from my paycheck, they printed and sent me monthly coupon payment thingies. I didn't ask for this. In fact I was fully prepared to pay back the loans. They just did it*.

The loan interest that you are paying, you are paying back to yourself. So, I think the only costs associated with 401k loans are the loan administration fees and the opportunity cost.


* My 401k at the new job is also managed by Fidelity but I don't know if this was a factor in their decision. Also, I quit a job at a huge tech company to start a job at a huge tech company. Between the two loans, I owed a total of ~$20K.

Since this is tax code... I wouldn't count on this to be a repeatable occurrence.  I would expect to get a 1099-somethingorother that categorized it as taxable income if not paid back.  And even if you don't... it's still taxable.  You might get caught.  You might not.

MustacheAndaHalf

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Re: 401k loan taboo
« Reply #27 on: December 22, 2016, 07:34:30 PM »
Hey poster,

I'll argue against the others and say it might make sense, but only because private student loans are worse than 401(k) loans.  A private student loan can never be discharged - you go bankrupt, it follows you.  You never pay it, and they take some of your social security payments to get their money back.  It's the most toxic debt I know about.

With a 401(k) loan, you risk losing everything you withdrew plus a 10% penalty if the loan is due and you can't pay it.  Maybe tax implications as well.  But it's your own money, and at worst you could consider bankruptcy.  With most student loans (especially private student loans), bankruptcy has no effect - you still owe the loan.

So given you're paying off more toxic debt with less toxic debt, and you're dropping your interest rate payments from 6.5% to 4.5%, it might be interesting to do.  You're losing 6.5% on that amount of money anyways, so why not reduce the loss to 4.5%?  Be prepared for the worst case scenario, though, and calculate what happens with a job loss where you need to repay the 401(k) loan.

rpr

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Re: 401k loan taboo
« Reply #28 on: December 22, 2016, 08:02:52 PM »
Hey poster,

I'll argue against the others and say it might make sense, but only because private student loans are worse than 401(k) loans.  A private student loan can never be discharged - you go bankrupt, it follows you.  You never pay it, and they take some of your social security payments to get their money back.  It's the most toxic debt I know about.

With a 401(k) loan, you risk losing everything you withdrew plus a 10% penalty if the loan is due and you can't pay it.  Maybe tax implications as well.  But it's your own money, and at worst you could consider bankruptcy.  With most student loans (especially private student loans), bankruptcy has no effect - you still owe the loan.

So given you're paying off more toxic debt with less toxic debt, and you're dropping your interest rate payments from 6.5% to 4.5%, it might be interesting to do.  You're losing 6.5% on that amount of money anyways, so why not reduce the loss to 4.5%?  Be prepared for the worst case scenario, though, and calculate what happens with a job loss where you need to repay the 401(k) loan.


In the event of a bankruptcy the 401k loan will likely be treated as a withdrawal. With all of the tax implications to follow. And if you are unable to pay the tax, you will be a debtor to the tax authorities.

cincystache

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Re: 401k loan taboo
« Reply #29 on: December 23, 2016, 07:30:57 AM »
There seems to be a lot of confusion on this thread.

#1. Will the loan be immediately "called" if you quit or get fired? It depends on the plan, my 401k plan allows the participant to continue paying down the loan in monthly installments if you leave the company. This is not illegal, it only turns into a distribution if you stop making your monthly payments. At that point, yes, you will pay taxes and 10% penalty. This is dependent on your 401k, read the fine print.

#2. Interest rates: Just so it is clear, the 4.5% interest is going to YOU, not the bank or your employer. So all these calculations where you "pay" interest are an unfair comparison, that interest goes into YOUR account. When you make student loan payments, your interest goes to the bank, never to be seen again.

#3 Taxes: you aren't paying tax twice on the 50k. You will pay tax twice on the JUST THE INTEREST (in this example $5,929). This is a common mistake when analyzing 401k loans. I had to really think about this for awhile but it is true.

#4.  You'll miss out on compounding: I think this is a really flawed argument in this case. If OP were buying a depreciating asset (car, vacation etc.) with the 401k loan then I would completely agree but OP is eliminating an unavoidable 6.5% interest rate loan IMMEDIATELY. Think of this as a guaranteed 6.5% return on that 50,000 for the next 5 years.  Most of the "lost compounding" will be mitigated by the avoidance of interest payments. Furthermore, OP's cash flow will be helped slightly by having a lower payment AND, the interest on the loan will end up in OP's own account at the end of five years.

#4b. Lastly, taking a 401k loan could actually work in OP's favor from a market timing point of view. I'm not saying it is ever a good idea to try and time the market, but OP could get completely lucky and the market could go down substantially shortly after the loan funds are disbursed. Then, some of the payments would be used to buy stock "on sale". Again, not saying this is likely but it is a possibility given the current stock market valuation.

Would I do it if I were in your situation? YES, but only if the following were true:
1)My plan allowed me to make payments even if I left my job
2) I had 6 months worth of 401k loan payments IN ADDITION to my normal emergency fund in case I lost my job


 
« Last Edit: December 23, 2016, 07:34:33 AM by cincystache »

Paul der Krake

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Re: 401k loan taboo
« Reply #30 on: December 23, 2016, 08:12:07 AM »
50k is not balance
I'll argue against the others and say it might make sense, but only because private student loans are worse than 401(k) loans.  A private student loan can never be discharged - you go bankrupt, it follows you.  You never pay it, and they take some of your social security payments to get their money back.  It's the most toxic debt I know about.
I disagree. At a loan balance of only 50k, bankruptcy shouldn't even come into the equation.

OP, have you looked into refinancing your loan at one of the sexy new companies like SoFi?

Proud Foot

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Re: 401k loan taboo
« Reply #31 on: December 27, 2016, 02:39:00 PM »

OP, have you looked into refinancing your loan at one of the sexy new companies like SoFi?

I was going to say this as well.  If you have good credit you should be able to refinance to an interest rate lower than the 4.5% you would get from your 401k loan.

Another thing I didn't see mentioned was whether your 401k plan has an additional loan fee. The 401k plan for my employer has a $2 monthly fee for each loan.  Not a huge fee but should also be consideredl.

SpareChange

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Re: 401k loan taboo
« Reply #32 on: December 27, 2016, 11:21:44 PM »
#1. Will the loan be immediately "called" if you quit or get fired? It depends on the plan, my 401k plan allows the participant to continue paying down the loan in monthly installments if you leave the company. This is not illegal, it only turns into a distribution if you stop making your monthly payments. At that point, yes, you will pay taxes and 10% penalty. This is dependent on your 401k, read the fine print.

This is how my plan works as well.