Three years ago I was purchasing a house and ended up taking out a 401(k) loan. At first glance, 401(k) loans seem like a pretty good idea. I can loan money to myself instead of paying mortgage interest to a bank? Sounds great! But here’s what I learned…
I knew that 401(k) loans had their downside, but I felt I was the perfect candidate for one. I needed a little extra money for a down payment to avoid PMI. I also had a very stable job that I enjoyed and thought I would stay at for the rest of my career.
Three years later things have changed. Even though I thought I would stay at my old job forever that didn’t end up happening. Life rarely turns out like you expect it to, and in the last couple of weeks I have resigned from my old position and found a new job.
So, was taking out that 401(k) loan the right decision? Let’s look at the numbers to see just how good with money I really am.
How the 401 (k) loan saved me money
The 401(k) loan saved me money in two different ways. First of all, the money I borrowed from my retirement fund was money I didn’t have to borrow from a bank, so I saved myself some mortgage interest expenses.
Let’s use round numbers to figure out how much money this saved me. Let’s say I borrowed $20,000 and my mortgage rate is 3.5%. That $20,000 balance decreased over time as I made monthly payments; so for purposes of this calculation I will use the average principal balance of my 401(k) loan during years 1, 2, and 3 multiplied by my mortgage interest rate. This isn’t the 100% mathematically correct way to do it, but it gives us an answer that is pretty darn close. We will ignore the effects of the mortgage interest tax deduction because I, like a majority of Americans usually do not itemize expenses on my tax return. So here is approximately how much money I saved on interest:
|Interest expense saved|
|Average Balance||Interest rate||Interest saved|
The other way a 401(k) loan saved me money is I didn’t have to pay PMI. Taking out a 401(k) loan increased my down payment to a point where PMI was no longer required. I would have otherwise had to pay $45/ month for PMI which is equal to $540/ year or $1,620 over the three years of my 401(k) loan.
So I saved $1,920 in interest and $1,620 in PMI. That’s $3,540 in savings, so the 401(k) loan is looking like a pretty good option so far.
What the 401(k) loan cost me
Depending on circumstances there are two or three ways that the 401(k) loan could hurt you. For one thing my 401(k) plan charged me a fee for having a loan. The initial fee was $150, and the yearly fee after the first year was $75. After three years I had paid $300 in fees.
The much larger way that a 401(k) loan hurt me was in lost income in my retirement plan. Because that $20,000 was pulled out of my 401(k), it was no longer working for me in the stock market. That means that $20,000 wasn’t making me any money. While it is true that my loan was earning 4.5% we won’t count that since I was the one who had to make that payment every month out of my paycheck. If we use the same average balances we used above and assume that my investments would have otherwise made as much as the S&P 500 Index made over the last three years, my lost income looks like this:
|Average Balance||S&P 500 gain||Income lost|
$9,718? Oh, #@%&! $9,718???!!!!??? That’s bad. Really, really bad.
|Total Savings/ (Loss)|
|Total fees and lost income||10,018|
|Net Savings/ (Loss)||(6,478)|
So we add the $9,718 dollars in lost income to the $300 in fees, then subtract the $3,540 in savings we calculated above that is a net cost of $6,478. Ouch. Taking out a 401(k) loan wasn’t the wasn’t the worst mistake I made in my life, and it probably isn’t the second worst mistake I made either. But I bet it’s in the top 5.
It is true that there is a little bit of bad luck built into that calculation in that I chose three really bad years to not have my money invested in. But, even if during 2012-2014 the stock market had gained a more average 8% per year that still would have meant I lost over $4,000 in potential income and the 401(k) loan would have cost me over $1,100 all things considered. Not very wise on my part.
But wait, it gets worse
Sadly, that’s not even the end of it. If you leave your job before paying off your 401(k) loan, a time bomb starts ticking. That time bomb is the fact that if you don’t pay your loan back within a few months (depending on the specifics of your 401(k) plan) it will be considered to be an early distribution. Early distributions are nasty because they require you to pay taxes on the full amount of the distribution plus a 10% penalty.
In my case, over the last three years I have paid my loan down to a balance of $17,000. Unless I can come up with that cash, and assuming I am in the 25% tax bracket, those taxes and fees will amount to almost $6,000! Add the taxes on to the loss I calculated above and that 401(k) loan could potentially add up to cost me $12,500.
The truth is that I think I am going to be able to come up with the $17,000 thanks to an emergency fund I have managed to put together over the last couple of years, so I won’t really lose the whole $12,500. I will still be losing enough to learn my lesson though, and I hope my story makes anybody considering taking out a 401(k) loan think twice.
About the author: Andy Prescott is a CPA who writes about saving money at artofbeingcheap.com.