Borrow from a 401k to pay credit debt?

[Guest telarsen]

Does it make sense to borrow from a 401k to pay off credit card debt?

[Guest 401der]

It makes more sense to take a second mortgage out on your home to pay off the credit card debt so you can take a tax deduction on the interest and let your tax deferred retirement account continue to earn interest tax deferred, hopelly higher than the rate you would get on a loan to yourself from the plan. By the way, you repay the interest on a plan loan with after tax money and is placed into a tax deferred account, so you will pay taxes on that interest twice.

[GBurns]

Provided that this person owns a home and can qualify for an acceptable HE loan.

Many people who reach the position of having to consider a 401(k) loan for paying credit card debt are at the stage where there are delinquency, foreclosure and collection issues that might affect even the possibility of an acceptable HE loan..

[ccassetty]

401der is correct that a HE loan would be better. Borrowing from your retirement plan should always be your last resort. Whatever way you go to pay them off, shred your cards so you are not tempted to run up more debt once they are cleared.

[mbozek]

Borrowing from a retirement plan has its advanges-the interest paid is credited to the participant's account which provides a safe, steady rate of return without volitility. A 7% return for 5 years is better than a negative return. Second for taxpayers in the 25% or greater tax brackets, interest on HE loans which are not used for improvements to the home is included as income for AMT.

[Bird]

A 7% return for 5 years is better than a negative return.

I never cared much for that argument. Heck, a 10% return is better than 7%. Why assume negative? And there're two parts to the equation - what is the participant going to do with the money? Invest it? Unlikely. IMO, it's all about the cheapest/best source of funds, and a plan is down the list, as far as I'm concerned.

If no other source of money is available though, using a plan loan to pay off credit card debt is probably worthwhile. You're pulling money from a plan where your expected return is maybe 8-10%, depending on what options you have and what you're invested in, and "earning" a guaranteed 18.5% (or whatever) by paying off the credit card debt. In that perspective, it's a no-brainer. The risk is thinking that you're really smart to be doing that when you were, um, not-so-smart (or possibly unfortunate) to run up the credit card debt in the first place.

FWIW

[mbozek]

A 401k loan can be used to pay for college with a guaranteed return that is 100 basis points over the return for investment grade preferred stock for 5 years. Very few individual investors will get a average 10% return on equities over any 5 year period (which requires a return of 11.5% before management fees).

[Bird]

Following that argument leads one to conclude that the "best" 401(k) loan is the one with the highest rates (e.g. 200 bps over prime instead of 100 bps).

It's not an investment, it's a loan.

[WDIK]

By the way, you repay the interest on a plan loan with after tax money and is placed into a tax deferred account, so you will pay taxes on that interest twice.

Just to be fair, there are other schools of thought with regard to this statement.

[Guest PatF]

Another consideration is what happens if you lose your Job. I did payouts for two people under 59 1/2 with large loans from their plan. Not only are they taxed on the money, but now they owe the 10% penalty. The distribution added to their normal income put them in a higher tax bracket also. Just some things to consider before taking that loan.

P

[g8r]

Agreed. That, to me, is the biggest risk with a plan loan.

I'm one of the ones who argues that there is no double taxation -- or more accurately, the tax effects are no different in borrowing from a plan vs. borrowing from another source. I'll spare you the math. Suffice it to say -- it takes after tax dollars to pay off the credit card today. And, money that is kept in the plan by not taking a plan loan earns interst and is taxed when withdrawn. If the loan is made from the plan, it still takes after-tax money to pay off the loan. Yes, the interest paid to the plan will be taxed when withdrawn -- but that happens regardless of whether the interest income was from a plan loan or from interst earned on the funds had they been loaned out.

As far as the rate of return, I'd suggest that right now a loan may be the best investment someone has in the plan. My 401(k) is fairly diversified and I lost money this quarter.

Outside of the risk of default, the loan from the plan should be viewed like any other fixed income investment. It may perform better or worse than other investments and that's just investment risk - not something particular to a plan loan.

So, I think paying off a credit card is a good use of a plan loan -- assuming the plan loan gets paid off. That's the real risk -- as well as the other traditional financial risks that are not unique to plan loans (such as not racking up the credit card again).

[Bird]

This concept of a 401(k) loan as an investment (not only an investment, but the BEST investment!) is starting to chafe me, sorry.

As if you have a choice - yes, I'll take 25% equities, 25% bonds, and oh, looky here, I'll put 50% in this "loan" investment and get a guaranteed 6%.

OK, there are circumstances where if you take money out for a loan you will not lose money that might have been lost if invested in equities. But you can achieve the same result (a little better, most likely) by simply moving the money to a money market account in the plan. (I am NOT advocating market timing; just making a point.)

[mbozek]

Why cant a plan loan be viewed as part of the diversified investments in retirement portfolio, e.g., a fixed income investment in debt. It pays more than a MM and has a 5 year term (similar to preferred stock). Default risk is limited to job loss.

[Lame Duck]

All of the major mutual fund companies advise against plan loans. Why? Because the loan removes the money from their control and they no longer earn anything on it. all of their assumptions and calculations are based on the erroneous (to my way of thinking) conclusion that payments made into the plan will not be reinvested so that money will sit useless until the entire loan has been paid back.

I once participated in a study that demonstrated a plan loan was definitely in the participant's best interest. He would have more money in his account at the end of the loan period, at the same rate of return, than if he would have if he had allowed the money to remain in the plan over the same period of time.

If the plan is going to provide a net return of 10% and the loan is providing a return of only 6%, the participant would generally be smarter to leave the money in the plan. However, you need to consider the net effect of the money saved between paying off the credit cards over time as opposed to paying off the loan to the plan. I'm not an actuary or mathematician so I don't claim these numbers are accurate, but I think they are close. One of you who is might check them.

Assume that the credit card debt is $5,000 and the interest rate is 18%. To pay that amount off over a 5 year period would require a monthly payment of $126.97. To pay off a plan loan of $5,000 at 6% interest would require a payment of $96.66. If (a big if) the additional savings of $30 per month is contributed to the plan with a net return of 6%, it would be worth $2,614. The plan loan would have paid a total of $5,980 into the plan, for a net gain of $980. Assuming a level payment of the interest to the plan, over a 5 year period, it would grow to $1,140, a gain of an additional $160. This results in a net increase in the value of the account of $3,754. The plan would have to achieve an annual net rate of return of 11.85% on the $5,000 to put the participant in the same position he would be in if he took the loan.

[JDuns]

The rate of return analysis ignores the fact that most plans impose a loan origination fee and many also impose regular loan maintenance fees that significantly reduce the net return on the loan investment.

In addition, the fiduciary issues on speed of crediting loan repayments, risk of errors in calculating and recrediting loan amounts, issues regarding loan defaults (especially when a participant declares bankruptcy) all make plan loans an unattractive option for plan sponsors/administrators.

[GBurns]

I do not recall seeing plans with "loan origination fees" or "loan maintenance fees".

I wonder if these are normal?

[WDIK]

I wonder if these are normal?

It has been my experience that they are very common.

[MoJo]

Pardon my jumping in, but I too am starting to "chafe" at some of the comments. With respect to a loan as an investment: It is an undiversified investment subject to to risk incalculable - unlike any other investment. First, it is subject to an interest rate risk that may be difficult to quantify - while a prime plus one return today may be better than a money market, two years out it might not be (and since prepayment on a plan loan generally means prepaying IN-FULL, cashing out of the "loan investment" for better alternatives may be impractical - as opposed to cashing out of a money market inside the plan). Second, it is subject to market risk - that your employer's labor needs may change and you now have a huge burden (repaying or tax) at a time when you can least afford it. This by itself should be a huge deterrent to a plan loan - as it PERMANENTLY removes the loan balance from your tax sheltered portfolio. To propoerly evaluate the real cost of the loan, you'd have to factor in the (unpredictable) likelihood of forced default and calculate the loss (permanently) of the compounded tax benefits of money remaining in the plan. Can't be done with any degree of accuracy. Finally, when you compare a 5% plan loan rate against an 18% credit card rate (well, first, consider that if you are paying 18% you should question your creditworthiness and ability to repay the plan loan first - I haven't paid over 2.99% in years on credit cards until very, very recently) consider the positive compounding of leaving the cash in the plan for say 20 or 30 years against the "negative" compounding (ever decreasing balance) on the credit cards, and in many cases, the positive compounding in the plan will produce a greater cash reward at retirement than the total cost of interest on the credit card. Factor in the protections given to qualified plan assets and the discargeability of credit card debt in bankruptcy, and I think plan loans should be considered an absolute LAST RESORT for cash.

You end up literally mortgaging your future....

[WDIK]

To propoerly evaluate the real cost of the loan, you'd have to factor in the (unpredictable) likelihood of forced default and calculate the loss (permanently) of the compounded tax benefits of money remaining in the plan. Can't be done with any degree of accuracy.

If the cost of these factors is essentially undeterminable, how can you use them as a basis for your argument?

[MoJo]

That's my point, WDIK. It is an uncalculable risk, and that indeterminate factor substantially increases the risk of a plan loan. In other words, you can't compare a plan loans (apples) to other credit (oranges) to determine which is lower cost potential cost. So the discussion about lower interest rates and a plan loan as an investment misses the point.

[WDIK]

If I may be so bold as to summarize part of your analysis:

Although some risks associated with taking a plan loan are incalculable and undeterminable, the possibility of these risks is enough to be a determent.

[mbozek]

Mojo: I dont understand how positive compounding as it relates to a plan investment will produce a greater cash reward than negative compounding for interest in a cc loan which makes the cc loan better than a plan loan. If I borrow $10,000 from a plan at 5% for 5 years, the total payments will be $11,276 (187.93 x60). If each payment earns 5% after it is paid to the plan, at the end of 5 years I will have $12,834 in the retirement account. If I borrow 10,000 @5% for 5 years with a CC loan I will pay $11,276 (187 x60) to the CC Co., for a negative payment of $1276 as compared to the positive $2834 earned in the retirement plan account at the end of the period.

Under new bankruptcy law CC debt will not be automatically dischargeable for many employees and will have to be paid back in installments.

[Bird]

Mbozek, I don't really want to get into it, but for the sake of anyone watching who thinks you just proved something, I have to comment.

First, you can't just add up payments over a time period and compare that to...anything. Second, you have ignored what the plan account would have grown to if you didn't borrow from it.

Forget about amortizing the loan and just keep it simple. One year, one payment, 5%. You assumed that the loan payments would earn 5% in the plan after they were deposited so I have to assume that's the opportunity cost of taking money from the plan. And it appears that the loan is used for consumer purposes, that is, the proceeds are not invested outside the plan, and the participant can come up with the payments out of his pocket.

OK, so if you borrow, you take $10,000 out and you put back $10,500 one year later. You have $10,500 in the plan at that point.

If you don't borrow, you earn $500 and have $10,500 in the plan at the end of a year. (And you will have borrowed $10,000 from a commercial lender and paid it back, just as if you had borrowed from the plan.)

No difference. That's because the keys to the analysis are the opportunity cost (what the money would earn if left in the plan) and the loan rate. If you assume other plan investments would lose money, then the loan will look good. If you assume modest investment returns on other plan money, and a high commercial loan rate, the loan will look good. If you assume modest to good returns on other plan money, and you assume that the participant doesn't really need the loan, but takes one anyway because somehow it's a "good" thing, and then you invest it outside the plan in something that doesn't have as high a return as the plan investments, then the loan will look bad.

[g8r]

By my prior post, I wasn't trying to say treat a loan like any investment (the fact that it is performing better than assets right now is true, but I really only use that as a joke). My point is that from a pure economic standpoint (at least as far as the known factors), it really can be viewed like an investment. The tax effects of borrowing from the plan vs. another lender is neutral. And, taking funds from an account to make a loan to yourself vs. to an outside party (e.g., buying a bond) is neutral. With either you have the same market risks - opportunity cost, changes in interest rates, etc.

I absolutely agree that it's the immeasuarable risk of default that is a problem. The consequences of defaulting on a plan can be horrible. However, consider my last point about financial planning. If someone is paying 18% on a credit card and can pay it off with a plan loan - AND not rack the card back up, there's your protection should you lose your job. Just use the credit card to pay off the plan loan. Yes, there are costs associated with doing that (transfer charges, etc.) but they are somewhat measurable and may still make the plan loan a better choice -- from a pure economic choice.

And no -- I don't recommend that. I suspect there are numerous studies out there showing that people will rack the credit card right back to where it was. There goes the protection, there's now more debt, and losing the job would just make the situation doubly worse. Which is exactly why some people say a line of credit on a home is equally as bad an idea b/c you can lose your home. It's really contingent on how disciplined someone is on not getting further into debt.

[austin3515]

Bird's on the money here...

The only economic difference (as someone said earlier) is the double taxation of the interest paid in. For the purpose of analysis you have to assume the same rate of return. Presumably, on a risk adjusted basis, the expected rates of return will always be equal anyway.