Borrowing from 401-K to wipe out a debt - good idea or not?

[Werewolf]

along with interest that goes to his 401K

The amount borrowed from the 401k earns no interest until repaid in full.

Brad

Not true. The amount he pays back into his 401K starts earning the day it goes in plus the 10% interest he pays earns once it is in there.

At the end of the payback period the amount in his 401K will be greater than it would have been without having taken the loan. The only way that would not be true is if he doesn't continue his normal contribution and what ever vehicles his 401K is invested in actually lose value over the payback period (which would be true even if he didn't take out the loan).

The interest he's paying goes into the 401K instead of to the CC companies.

Guys this isn't rocket science.

If you've got excel just create a simple simulation. Assume a fixed rate of return (5% is a good choice), a starting value for the 401K, a fixed contribution over a fixed amount of time and walk it down to see the Future Value. I'd recommend using a monthly interval.

Do the same thing again only this time take out the amount of the loan from the beginning value. Assume the same fixed rate of return. Add in the payback amount plus interest in addition to the fixed contribution for each period (since the OP says he will continue that). Again walk it down month by month for the same period of time. You'll see that he'll have more doing the loan than not.

I set up an example:

Assume the OP has 25K in his 401K and it is earning 5% per annum compounded monthly. He is contributing $200 per month. At the end of 24 months his 401K will be worth $32,326.03.

Now assume that he borrows 10K from his 401K. At 10% and a 24 month pay back his monthly pay back will be $461.45. He continues to make his $200 contribution. Since he took 10K out of his 401K it is now worth $15,000. For 24 months he continues to make his $200 contribution and the $461.45 loan payment.

Assuming his 401K continues to earn 5% per annum at the end of the payback period his 401K is now worth $32436.74. His401K is worth more by $110 dollars.

The OP is actually better off than that because his interest rate was half what it would have been but I'm not going to waste any time figuring that out because it is self evident.

I've run this at various positive rates of return on the 401K and it always is beneficial to the OP to take the loan out of his 401K.

I'm really having trouble fathoming why this is so hard for y'all to understand. Maybe y'all put more value on the intangibles than the hard numbers. <shrug> I'm done.

[Brad Johnson]

Not true. The amount he pays back into his 401K starts earning the day it goes in plus the 10% interest he pays earns once it is in there.

That depends on how his 401k and the loan is set up.  Some do, some don't.  Some even charge a "service fee" for borrowing against them.

Brad

[Werewolf]

Not true. The amount he pays back into his 401K starts earning the day it goes in plus the 10% interest he pays earns once it is in there.

That depends on how his 401k and the loan is set up.  Some do, some don't.  Some even charge a "service fee" for borrowing against them.

Brad

That I did not know. Learn something new every day...

[Brad Johnson]

The only reason I know is a good friend learned the hard way.  It wasn't pretty.

Brad

[mek42]

I still regret taking a withdrawal from my Roth to cough up the little extra needed to buy our first house.  We're living within our means now  and making an effort to pay down our cards but every time I look at my Roth now the number is so small.

One of the things that has helped us is that we have locked our cards up in the gun safe.  This eliminates the vast majority of impulse buys.

[K Frame]

"That I did not know. Learn something new every day..."

Yep, the employer and plan administrator have a LOT of control over loans.

My employer will only allow loans for purchase of a new home.

[Green Lantern]

Ah yes, there IS a pesky $50 fee.  They make SURE you know about it, at least when requesting a loan by phone.  But when compared to the money I SHOULD save on CC interest charges alone...

There are also two "classes" of loans - Primary Residence and General Purpose.  Don't really know the diff offhand - IIRC, it may be the repayment period.  The MINIMUM you can stretch out your payments for a GP loan is 1 year, I think it may be 3 years for the home loan.

Hmmm, hmmm, and hmmm....

Again, though I'm a good employee of 9 years and (IMO  ) a very valuable asset (I even abide by their stupid "no guns at work" policy ), I'd HATE to take the give-or-take 50% "hit" on that loan courtesy of Uncle Sam if I lost my job and couldn't repay it in time.  Some things in life you just can't predict.

Then again, regarding the risk of messing up my income during retirement - not to be morbid, who can predict for sure that I'll REACH retirement???   

[K Frame]

If I don't make it to retirement the children of three of my best friends are going to be quite wealthy.

Of course, if my Mother outlives me, she gets it all.

[The Annoyed Man]

"That I did not know. Learn something new every day..."

Yep, the employer and plan administrator have a LOT of control over loans.

My employer will only allow loans for purchase of a new home.

My employer gives out personal loans to "valued" employees. Some have purchased their homes or remodeled with these loans. All our employees even the "non-valued" ones can borrow $1,000 at any time during a fiscal year for any purpose.

[Tuco]

 

...Maybe y'all put more value on the intangibles than the hard numbers. <shrug> I'm done.

Yep, you're right.  I place more value on integrity, responsible behavior and family duty ("intangibles") than hard numbers.
Silly me.

[BrokenPaw]

...Maybe y'all put more value on the intangibles than the hard numbers. <shrug> I'm done.

Yep, you're right.  I place more value on integrity, responsible behavior and family duty ("intangibles") than hard numbers.
Silly me.

Don't bang your head when you ride that high horse under a low bridge. 

The OP asked a question about what made financial sense, and Werewolf, as a financial planner, gave hard numbers and a couple of strict caveats for the OP to follow in order for those numbers to apply.

Werewolf said "if you do this, and strictly do this, what you said makes good financial sense".  At what point do those numbers change because of "integrity, responsible behavior, and family duty"?  Such condescension is unseemly.

-BP 

[Firethorn]

Ah yes, there IS a pesky $50 fee.  They make SURE you know about it, at least when requesting a loan by phone.  But when compared to the money I SHOULD save on CC interest charges alone...

There are also two "classes" of loans - Primary Residence and General Purpose.  Don't really know the diff offhand - IIRC, it may be the repayment period.  The MINIMUM you can stretch out your payments for a GP loan is 1 year, I think it may be 3 years for the home loan.

It's sounding a lot like a TSP loan then.  The difference I've seen for the TSP versions are how much you can take out, and the maximum repayment time.  I took a TSP loan out to help buy my house, it was substantially cheaper than bank loans at the time(still is), even considering 'lost income' because the interest rate I'm paying myself is less than industry returns.

[Tuco]

At what point do those numbers change because of "integrity, responsible behavior, and family duty"? 

At this point...

I'm really having trouble fathoming why this is so hard for y'all to understand. Maybe y'all put more value on the intangibles than the hard numbers. <shrug> I'm done.

The op has made a habit of spending more than he makes.  Until that behavior changes, there will be no professionally formulated financial magic act that will solve the problem.

We can spend all night posting different scenarios into excel,  but with income less than expenses, the problem will appear again and again.  Men who thrive on debt (bankers, financial professionals) seem to ignore this simple fact, and offer to toss another pin into a failing juggling act.

You may call that condescension, that's your right.   I'm calling a spade a spade. 

I apologize if my curtness offends you.  This is an arena in which i have vast personal experience and am able to speak from the high horse only because I got my ass kicked out from under me.  And if I ever knock my head on the bridge, I know how to cure the pain...  that's right, by spending less than I make.

[Werewolf]

Men who thrive on debt (bankers, financial professionals) seem to ignore this simple fact, and offer to toss another pin into a failing juggling act.

Except in this case the OP would be exchanging high interest debt for low interest debt and paying the interest to himself. That's a good thing not a bad thing as it saves him money.

This reduces his expenses and as long as he continues to contribute to his 401K he is ahead.

Should he change his spending habits? Based on what little he's told us probably.

As for your description of men who thrive on debt - I'm not a believer in personal debt except for CARS, and homes, neither of which the average person can pay for out of pocket. Credit cards are useful if they are paid down to zero each and every month and that's what I advise people who ask about them to do. If you can't pay them down to zero each month then you're charging too much. At that point you reduce what you're charging and consider the CC's to be for emergencies only when you absolutely have to get something done NOW and you don't have the money to pay for it NOW! And I'm not talking about buying that stereo you really want or those once in a life time concert tickets.

Debt is a tool and like any tool it can be mishandled, abused and cause problems. This is as true for businesses as it is for individuals.

No responsible (pay attention - key word responsible) person in the financial industry creates unnecessary debt for any of his/her clients - that's a losing proposition for both the financial person and the client. Unfortunately a combination of government regs that force banks and other lending institutions to lend to people not qualified to repay and a desire to test the limits of risk by some has led to a perception of finance folks much like you've developed. There's nothing we can do about the gov regs but the marketplace will take care of the extreme risk lenders.

[Northwoods]

As for your description of men who thrive on debt - I'm not a believer in personal debt except for CARS, and homes, neither of which the average person can pay for out of pocket.

Bull hockey on the cars.  Partial bull hockey on the house.  The average person can certainly pay cash for their cars.  They just need to get out of the mentality that they need a brand new car every four years.  Start out with whatever you can afford to pay cash for, even if that's a $1000 beater, and pay yourself a car payment.  Average payment is close to $450/month.  After just 10 months you can step up to a $5500 car.  Within 4 years total you can be driving a paid for $20k car.  Most people won't even pay off that $20k in 4 years if they follow your advise to finance their cars.

For a house, the ability to buy one for cash depends on where you live, how much you make, and how cheaply you're willing to live until you buy that house.  Where I'm living in Seattle if you want anything but a 700sf cottage in a bad neighborhood it'll take too many years, even with a 6-figure income, to get there without a mortgage.  But, my sister lived in Columbia, SC in a pretty decent house that cost $90k.  A house like that could be bought with cash with a few years of savings if you have a good paying job and are motivated.

Credit cards are useful if they are paid down to zero each and every month and that's what I advise people who ask about them to do. If you can't pay them down to zero each month then you're charging too much. At that point you reduce what you're charging and consider the CC's to be for emergencies only when you absolutely have to get something done NOW and you don't have the money to pay for it NOW! And I'm not talking about buying that stereo you really want or those once in a life time concert tickets.

Dunn and Bradstreet did a study that showed that people on average spend 12-18% more with plastic than with cash.  There have been brain pattern studies done (sorry, no reference handy) that showed why.  When handing over Uncle Ben's to buy that item a person actually experiences something very similar to physical pain.  That effect is greatly reduced when swiping a CC.  The newfangled chips they're putting in cell phones and such to charge purchases reduced that effect to almost nothing. 

Debt is a tool and like any tool it can be mishandled, abused and cause problems. This is as true for businesses as it is for individuals.

Debt amplifies whatever you're doing.  If whatever you doing is working it can increase your returns.  But it will also amplify your mistakes and can sink you faster than you can blink.  The stock brokers that jumped in 1929 were the ones that were highly leveraged. 

[Fly320s]

Green Lantern,

Have you tried calling your CC company and asking for a lower interest rate?

[MechAg94]

I tend to agree with Two Cold Soakers.  I wouldn't go the 401K route no matter what you can say about how it makes sense.  I agree that there may be some personal responsibility issues here the OP needs to deal with to get his finances on track.  IMO, the issue of living within your means and setting yourself up with some savings is very important.  IMO, if you don't deal with those issues, the temptation to borrow from savings all the time will always be there. 

It sounded like he only has to bite the bullet for a little while longer to get that car paid off and then he can apply his resources to the CC.  Yeah, the interest is a problem, but as long as you have a plan, you aren't talking about a great deal of time.  Me personally, I don't like the idea of juggling loans when it comes to personal finances.  I know it can be done right and it can work, but it isn't for me. 

[MechAg94]

I know a guy who got into CC debt some years ago.  He got a new job that wasn't paying a great deal at first, he had two kids a few years apart.  I think he was making good money by the time he accumulated the debt, but it was there (at least 5 figures).  He ended up cutting up all his credit cards and getting a debt consolidation loan.  His wife didn't like losing her credit cards, but I think she finally realized that he made more than her dad did and they would be "rolling in it" if they didn't have that debt to deal with.  He's paid off that loan now and they are doing pretty good. 

If you really want to do the loan, fine, just make sure you are very careful and make sure you live within your means and take care of paying everything off.  I wouldn't do the loan myself.  In the example above the debt wasn't something he could pay off in a reasonable time. 

[MechAg94]

Me personally, I paid off my truck and a piggy back loan last year.  I really love that my only debt is my primary mortgage.  The extra money per month beyond the 12% 401K is a great thing to have.  I am currently working on getting up to 6 months worth of savings.  However, the temptation for more guns along with the HD TV I just bought makes it tough to stick with the plan. 

I remember a financial guy I listened to a little a few years back suggested that no one should buy a car unless they can pay off the loan in 2 or 3 years.  His opinion was also than new cars make no financial sense.  I think he was one of those guys who says you should live on only 50% of your income.  Now that I am where I am, I can see the sense in this.  At the very least, it is a good idea when you are figuring your basic monthly expenses. 

[Green Lantern]

Have you tried calling your CC company and asking for a lower interest rate?

Not yet, but I think I AM going to do that before considering the loan. What's the worst that can happen, right?

Uhhhhh...they wouldn't RAISE my rate, would they???    (only semi-joking)

Ya know, when I first got that card, the limit on it was $500.  Then about every year or so they'd automatically increase it - $500 to $1000, $1000 to $1500, until I eventually got a $6k limit on my card.

Should I take it as a "sign" for anything (especially getting a better rate) that they HAVEN'T raised the limit in over a year now?

******************

Bull hockey on the cars.

I live out in "the sticks" with a 30-mile commute each day - a car is NOT an "option" for me, it's a must.

My car is a 2003 Subaru Impreza 2.5 RS (thank GOD I didn't get a Turbo, between ins. rates and PREMIUM gas prices!).  I bought it "very lightly used."  As I said, I plan on paying it off and keeping it until it falls apart.  My dad asked when I was gonna trade up, I looked at him like he'd grown another head.  And I plan on SAVING my car payments, so I'll at least have a nice down payment when it does go kablooey.

I've driven my share of $1000 rattle-traps.  For the time, money, and AGGRAVATION in keeping them running smoothly - I'd much rather spend the $$$ on a newer and reliable car, and keep it up with proper maintenance.  Lordy, I don't know what I'd "trade" for it though, but how I wish I had some hardcore MECHANICAL know how, like my brother or my cousin's hubby.  The latter has kept a $500 Ford Escort running for years now.  Though at the cost of a LOT of his time, sweat, blood, and probably money too...

Then AGAIN...

A big hunk of my debt was about $1K I had to spend on new struts and mounts - I guess all the gravel roads I have to navigate weren't kind to it.  But the humdinger that could have RUINED me, if not for being under WARRANTY, was some odd engine troubles.  Some really major work had to be done.  But, at least there wasn't a penny out of my pocket for any of that (even the rental for two weeks).

Right, now I might have mentioned my earlier loans.  Two big problems with those were that I didn't have enough in my 401K at the time to totally wipe out either debt.  And what I did take, I didn't FOCUS on ONE debt, I spread it out.  "Seemed like a good idea at the time!" 

But no, now, IF I do this thing, one or the other is getting NUKED.

So, I got some calls to make.  Need to call the CC company about the possibility of a lower rate.  Need to call the bank that financed my car loan to see what my actual amount owed is.  I've always tried to pay at least a SMIDGE more than the minimum, but I think a few payments have gotten delayed in the mail, too...so late charges might have wiped out those gains..

***********************

Anyway, the Lanterns NEW plan, PD (post-debt):

-SAVE SAVE SAVE!

-If I can't pay cash (or write a check) for it - SAVE some more then come back when I CAN!

Ummm, and I probably need to work on the whole RESIST TEMPTATION thing, to avoid depleting the savings too much.

...you guys won't think TOO harshly of me if I pay cash for my very first 1911, as a present to myself after I'm debt free and have at least a 3-month emergency fund in the bank, will you?

[Firethorn]

His opinion was also than new cars make no financial sense.

I think that it depends on your knowledge.  Today, by getting a new car you get the warranty, lower interest rate, and you know the maintenance and driving the vehicle undergoes.

Yes, you lose a lot of value in the first couple years - but the only reason I got rid of my saturn after 6 was that it ended up being totaled.  The truck I replaced it with I plan on driving until a similar situation occurs.  I have a 5 year note on it, but plan on making double payments.  That should have it paid off in ~2 years.  Part of the reason I went new is that I simply couldn't find a used truck that fit what I wanted at a good price.  I had been looking for a truck for months, intending on having two vehicles.  The loss of my primary vehicle put the vehicle search in a new light.

Yes, if you plan on keeping a car for only four years, you're probably better off leasing if you MUST have a new vehicle.

Not to mention, that if you have good credit a new car can actually end up cheaper considering all the above given that you generally get a lower interest rate.

On the debt thing - It can make sense to get a loan for something when the cost of the loan is lower than the opportunity cost of not taking it.  Take a house, for example.  There are substantial costs involved with buying/selling a home.  Commission fees, moving expenses, deed transfers, title insurance, etc... 

Given the combination of low interest rates and the tax deductions, it can make sense to move into the home you'd be able to pay cash for in ten years now.  By doing so, yes, you pay thousands of interest, but you also save thousands of expenses and get to be in the nicer house now.

Same can be said with a car - why go through the expense and hassle of getting a 'make do' car now, when for around a grand of interest you can get the new car now.

Note that I'm assuming a house is necessary, or at least can be had for less than renting, even with insurance.  That a car is necessary - that alternate transport is either more expensive than the interest or not available.  It can be stretched to things like home appliances, even a TV, but for a TV I'd rather recommend doing without for a month or two then buying(if you KNOW that the 19" TV won't satisfy you).

[Desertdog]

I feel that if you have decent running "town cars" that is paid for, it is cheaper if you want to go on a fairly long trip  to rent a car than to have a almost new car with payments.

My son recently paid off his wife's car that they have had for several years and they wanted to buy a newer model car for his wife.  I kelp telling him that one months car payment could pay for a lot of repairs.  They changed their minds and still jhave their old car.

[Firethorn]

I feel that if you have decent running "town cars" that is paid for, it is cheaper if you want to go on a fairly long trip  to rent a car than to have a almost new car with payments.

I've proposed something much along these lines if electric cars ever become popular.  It's not much of a stretch if you want to take a long trip, for say, one week a year outside of town to simply take your electric down to the rent a car place and pick up a gasoline model if you need the longevity.

A rental car for a week is going to run $480-$350.

Let's look at the cost difference between a truck and a 'decent'* car.  About $5k in price, from what I've seen.  I'm going to go with a 5 year lifespan, simply to keep it simple.

That's $1k a year in extra capital cost.  The truck will probably use 50% more fuel.  Figure going from 30mpg to 20mpg.  6K miles/year.  For the car, that'd be 200 gallons of gas.  For the truck, 300.  @$4/gallon, that's an extra $400/year in gasoline.

So, discounting cost of capital, extra insurance, etc...  The truck(or SUV) will cost you ~$1400 more a year.

You can rent a U-Haul, moving van, or otherwise more capable vehicle for ~$50-100/day.  If you're not using the extra capacity for at least two weeks a year, it's not worth it.  Personally, the truck is worth it for me - I needed a vehicle more capable in the snow&ice(4WD vs 2WD w/unlimited slip, 4 months a year).  I'm working on my house, so need to be able to haul wood & other large supplies.  Delivery companies want more to go out to my area.  I bought one of the smaller trucks available(grumble, still a bit big in my mind).

Once I get it paid off, I'm likely to buy another fuel-sipper, preferably a real one.  My saturn was a fast little car and got 30mpg despite my lead foot.  I test drove an even smaller car, anemic, and it's only rated at 34mpg highway?  They should be able to do better.

*Everybody has different ideas of 'decent'.  Feel free to change the assumptions to fit yourself and your area and usage.

[Green Lantern]

Doh, one more thing I forgot about asking before:

"Payment Protection" - worth it or not?  I've always had it, but I hear that it may not be worth ANYTHING (let alone what I'm paying for it...)

[Desertdog]

IMHO I hink it probably depends on a number of things, such as;
Your health, are you in good health are is there a possibilty that you may die or get disabled?
Your lifestyle, do you do things that may result in your death or disability?