I have always considered that choosing a companion for life was a very important affair and that my happiness or misery in this life depended on the choice.
— Ezra Cornell
Just so there’s no confusion about my prior post on 401(k) loans, let me be clear: while Suze Orman and her ilk are dead wrong to say that they are always a bad idea, that doesn’t change he fact that they are usually a bad idea, in the same way that credit cards are — most people tend to use them poorly, and can get themselves into trouble by doing so. So don’t go thinking I was recommending you go willy nilly with them.
Now that that’s settled, let me share an example of putting a 401(k) loan to good use. A while back, a friend of mine was fretting about not being able to save as much as she’d like, in part because of having to make student loan payments every month. I looked over her finances, and discovered a few things:
- She had over three times as much money in her 401(k) as her student loan balance.
- The loans were at 6% interest.
- Her savings rate was already substantial.
- She had a solid emergency fund, but she didn’t want to raid it to pay the loans down.
- Her job situation was stable — she had been at the company for over 13 years.
- She lived in a rented apartment, and had no other debts.
This situation practically begs for a 401(k) loan. She was able to borrow enough to pay off her loans completely at 4.25%. Not only was her interest rate reduced, she was now paying it to herself instead of the bank.
To understand how this pans out, it helps to look at the 401(k) and her post tax finances as separate entities.
From the perspective of her 401(k), since she borrowed about 30% of her balance, we moved the remainder into a stock index etf, for a roughly 70/30 stocks-to-fixed-income ratio — a perfectly reasonable allocation for almost any age group. As a bonus, the fixed income portion (i.e. her loan) was now earning much more than the bond etf options she had available. In short, her 401(k) was actually in better shape than before.
From the perspective of her after-tax accounts, she was now paying a lower interest rate. Her new payments were slightly higher, since the 401(k) loan had only a 5-year term (as is typical), but as I mentioned earlier, her savings rate was high, and she could easily handle the temporary reduction in cashflow. All in all, she’d pay off the balance faster, and pay much less interest, so the post-tax side of her finances was better off as well.
As you can see, this move was a winner all around. In fact, she was so impressed with how well my plan worked out, she married me! 1
Some things to note:
- Sure, the interest (but not the principal!) she was paying herself was post-tax, and will be taxed a second time — in 30 years. Compare that to higher interest payments made to the bank — a “tax” rate of 100%.
- Like most profitable financial moves, this entailed some risk. She could have lost her job, for example, or some other misfortune could have arisen that kept her from being able to make the payments, resulting in a nasty tax liability. She also could have been hit by a stray meteorite or run over by a bus. There are always risks in life — the best you can do is manage them sensibly.
- This worked for her because she had a responsible relationship with money, a stable employment situation, extra cashflow to cover increased payments, a solid emergency fund, no other debts, and no proclivity to take on new ones. (Yep, I married well.) If you can’t say the same, better think twice before trying this.
Score — Blind allegiance to “Experts”: 0. Thinking for yourself: 1.
- One would hope that a few other factors were at play in that decision, but who knows? Maybe that’s what clinched it. ↩