A 401(k) Loan Example

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.

  1. One would hope that a few other factors were at play in that decision, but who knows? Maybe that’s what clinched it.

4 Comments

  1. wooing and winning with money management. 🙂

    Why not use the emergency fund to pay off the student loan and think of the 401k loan potential as the emergency fund in the hopefully unlikely event of an actual emergency?

    • Sean Owen

      We considered that – we ultimately went the other way for a couple of reasons. First, getting the 401(k) loan set up took a few weeks, so it wasn’t really a good candidate for an emergency backstop.

      Second, she was adamantly against going below 6 months’ expenses in her emergency fund for any reason other than an actual emergency. Can’t say I fault her for this.

  2. Prob8

    I don’t recall what your house situation is . . . but a line of credit might have been an option too. This makes a couple assumptions about interest rates and tax deductions. Anyway, nice example of a good use of 401(k) loans.

    • Sean Owen

      I suppose my use of the word “we” above confuses the matter a bit, but this was a plan I put together for DW while we were dating. (Actually fairly early in our relationship.) She was renting and had no other assets to speak of that she could borrow against.

      Still, I think this was a better move than consolidating with home equity would have been. You may be able to deduct home equity loan interest, but that only amounts to a 20-40% discount at best, depending on your tax situation, and only to the extent you exceed the standard deduction (a detail many forget). The rest still disappears down a black hole.

      I may think differently if I thought there were ANY further capital upside in bonds. But pretty much all the capital risk in bonds nowadays is on the downside. They may stay where they are for a long, long time (cf. Japan), but it’s hard to imagine them going much higher.

      That’s why getting 4.25% on a short-term loan is among the best “bond” investments you can make right now (again, viewed in isolation). Not only do you have a better yield without your money being tied up for too long, your principal isn’t at risk from a shift in interest rates.

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