guitarplayer

At lunch today a friend told me how he bought his 06 E350. Said he put 1/2 down and taking the other half from his 401K in the form of a 5 year loan where the interest rate of 6% is paid to himself! I always heard you should never touch your 401K but taking 25K was pretty much un noticable and he pays himself back with interest.

I'm trying to find holes in this method, but is sounds pretty good for those in a position of a large 401K. Anyone know about this pros and conns?

CE750

My Morgan Stanley portfolio allows for this, and it's not a bad idea, if you have a major opportunity cost issue.. but the same can be said for using a HELOC and deducting the interest off your taxes.

On a car, being depreciating asset, cash is always King.. As I said before, I paid 85% cash and financed the rest just to "Exercise" my credit.

PHXATC

The amount that is away from the 401K doesn't earn any money (if said investment were to go up). Sure you pay "yourself" interest, but is it really worth it to gamble your retirement?

I bridged myself 15K while moving into our new house this summer, but immediately paid myself back after having it "out" for only 2 1/2 months. Safety net of sorts to get all the lovelies associated with a new house/property.

Hell, it's your money do what you want to !!!

black-e

Actually, the funds do remain invested and therefore do participate in market movements. You are simply repaying the "loan" with imputed interest. This is essentially an interest free loan as you are both the lender and the borrower. You pay yourself back with intrest. As stated previously, you could achieve the same results using a HELOC; however, the interest deduction is only offset by your tax rate whereas you recover the interest as you pay it back to yourself.

PHXATC

I stand corrected.

Damn, there's always somebody smarter than me!!

lexrex

Are you sure that the loan money remains invested? This Motley Fool article says the opposite -- that you do lose out on potential market gains (and losses) on the money you have out for a loan.

If the loan money does stay invested, as you say, it's a great deal.

But if it doesn't stay invested, then it's not such a great deal in the big picture. Although you may save a few interest points on your purchase in the short run, you're sacrificing part of your retirement for the long run.

Air Marshall Eldritch

One more risk to borrowing 401k money...unless the rule has changed recently, you will be required to repay the entire loan within 30 days if you leave your current employer for any reason (including involuntarily). If you have no means to do so, the loan transfers in status to early withdrawal, triggering 10% penalty plus income tax. Meaning almost 50% of the borrowed amount is gone.

Hank

for a guy in his mid 20s, $25k from 401k may have a larger effect down the road, for a guy nearing retirement age, $25k is just paying interest to himself.

black-e

The 401K plan will specify any restrictions on fund access. A hardship withdrawl will certainly reduce principal and trigger the penalties previously mentionied. Certainly early termination is risk that must be considered.

The real issue that is considered has been mentioned previously, and that is the opportunity cost. If a traditional car loan from a bank costs 4% and your 401K invested in a 50:50 mix has a total return annualizing at roughly 6-7%, then you will never recover your interest costs on a traditional loan as that is a definite outflow of funds to the bank. Think of the loan against the 401K as leverage of capital. Remember, leverage works both ways.

Having said all this...bond rates are still historically low and may remain in this range for the next year or so. Bottom line is money is still cheap and all things being equal, there is greater likelihood of appreciation from stocks than there is new issue 6% treasury coupons for the next few years.

smazur

Borrowing money from your 401k is one of the worst things you could ever do. You lose all of the market gains both real and compunded that the money would have earned for the time it's out of your account. Try running it through a financial calculator sometime and you'll see. The exceptions for borrowing from your 401k are to buy a house which is an asset that will appreciate over time. With a house you could end up making money after the house appreciates. You are MUCH better off taking out a regular car loan than borrowing from your 401k. Ask any professional financial advisor before considering this horrible move.

It's a rookie mistake that should only be considered if you are competely broke and facing bankruptcy. And if this is the case, then you should be considering a Neon, not a Mercedes.

guitarplayer

Let's say you have 500K in your 401k. You borrow 50K from it. They mail you a check for 50K. Doesn't your 401K now reflect that you have 450K? And you are only seeing market appreciation or depreciation on the 450K that is left in the fund plus the ammounts that you are paying back into the fund?

I still don't see how this is a bad deal.

smazur

$50,000 invested today compounded annually at 8% interest is somewhere in the neighborhood of $230,000 assuming you'll retire in 20 years.

The same $50,000 borrowed at 6% interest for 5 years you'll repay a total of $58,000.

You're only paying $8,000 in extra interest versus losing a potential of $180,000 by borrowing against your 401k.

This calculation has a flaw in that it assumes that you'll never repay youreself. You will, but you will always lose the time value of the $50,000 and all compounded interest from now until you retire. The key is that the interest compounds on itself, meaning that the interest makes more interest every year after that.

The point is that you'll get much more value out of the 401k money compounding over time than you will by repaying yourself back.

Do a simple search on "borrowing against your 401k" and you'll see that in any other case excpet hardship withdrawals and home purchases, this is a very BAAAAD idea.

guitarplayer

Yes, but 401K loans have a maximum of 5 years to pay back, not 20 years like you proposed. Plus, you don't lose out on the entire 50K since each month you will be paying that back and that money will be subjected to market appreciation.

smazur

OK I was afraid you were going to make me actually do the math here...
Let's assume a $50k 401k loan, assuming 8% capital appreciation, and that you have 20 years until you retire. Let's also assume that you can get a car or home equity loan at 6%.

The issue here is that every year that your money is out of your 401k it will not be appreciating. That money compounds onto itself and thus earns more money. So my calculations below are based solely on the interest that the missing money is earning.

The first year alone you lose all the interest that your 50k will earn. x .08 =$4,000. $4,000 compounded annually over 20 years at 8% is $19,707.

That right there is reason enough to not do it. A car loan will cost you approx $8,000 in interest.

And that's only considering the first years lost compounded interest. Assuming you'll repay 10k per year for 5 years - In year 2 you'll lose 40k x .08= 3,200. Year 3 30k x .08. Year 3 20k x .08. Year 4 10k x .08.

That's $15,000 worth of interest that will not be there to compound annually for the next 20 years. The interest alone compounded annually 15k at 8% over 20 years = approx $73,000. Now $73,000 may not be a lot of money to someone who has $500k in their 401k but compared to paying $8k back against your car loan it's a lot. So why would you pay an extra $61,000 for that car. Because that's what it's actually costing you if you consider this option. Consider it $58,000 to buy the car with a loan ($50k loan + $8k interest). OR... $123,000 to buy the car by using your 401k ($50k + a lost $73k in 401k gains).

This is finance 101 and a very common trap that people often fall into. Do youself a favor, money is cheap to borrow. Take out the car or home equity loan, pay the bank their 8k in interest and keep your retirement nest egg in place as is. Most people don't truly understand how your money can continue to make more money if it's invested over time. Hopefully, my (crude) calculations here have convinced you that you're really paying an extra $73k for the car .

If you still don't see the logic here, please have the sense to consult a tax planner, financial advisor, or CPA to sit down with you and show you what a bad move this is.

black-e

There is one flaw in your assesment. The S&P index has a total return including reinvested dividednds of -.225% (12/31/00 to 08/31/05) verses your assumption of 8%. So for an individual who was considering borrowing from their 401K during this time, and using a 5 year payback, they were better off borrowing than investing in hypothetical compounded returns. This is the real opportunity cost. I don't think anyone disagrees with your comments regarding the compounding of interest on interest. However, the linear assumptions of returns over time is not an absolute certainty.

smazur

I can agree with that statement for the period you stated. I use 8% as a generally accepted percent appreciation of the S&P over the last 40 years. In order for this 401k loan to make sense you'd have to assume a market gain of less than 2% compounded for the next 20 years. Do you really think that the market will only bear 2% per year for the next 20?

I'll give an excpetion of when I bought my car in 2000... I agonized over how to pay for my E320 and whether or not to take out a bank loan or take the money from my brokerage account. I decided to pay cash because I didn't want the loan and took money from my heavily invested tecnology stocks and mutual funds to pay for the car. So I'm down $50k and have a nice car... Well over the next couple years that same $50k would have been killed by the market over 80% in the stuff I was invested in. So in that case buying a highly depeciable asset worked to my advantage. The car depreciated less than my cmgi, qualcomm, and dell stocks would have... I lucked out! But what would have happened if I was stuck with that decision in 1995 when the market was giving 20-30% gains? I didn't want to push my luck as I only started with around $15k which grew to the $50k that I took out.

guitarplayer

Yeah, I wasted so much money on 2002 on EMC, INTL, CSCO. Still in the toilet!