Thursday, January 26, 2012

I have a confession to make: 401k loan

I never claimed that my student loans were all of my debt, but I didn't tell the whole truth either.

When we were buying our house, I had a few thousand dollars saved. I had been working full-time for less than a year after a dismal bout of grad school. In terms of saving rate I think I was doing pretty well though I don't have any numbers for you. My 401k comprised a plurality of my assets at around $8k.

I came up with around $15k for a down payment with my girlfriend covering the rest. To reach that target, though, I really had to scrape. I sold $3k of a mutual fund my mom bought when I was in grade school. I had $1k of stock in a Scottrade account that I liquidated. I had around $6k in cash. The difference came from my 401k.

I did an early disbursement for $900, which was all they let me take out. This was taxed as income but there was no penalty because there's an exemption for first-time home buyers. I'm not sure how I feel about that provision of the US tax code. It seems an unfortunate consequence of the fact that most household savings is in retirement accounts since most Americans suck at saving money. I bet if people couldn't raid their retirement accounts for a down payment, like I did, then a lot fewer people would be buying houses.

I also took out a loan of $4200 against my 401k. This was a very interesting option. I hear every 401k is different so I don't think this is available everywhere. The way it works for me is as follows: I can have one loan out at a time, for an amount up to half of the vested value of my 401k. When the loan gets dispersed, my funds are liquidated and then replaced with this "loan" investment vehicle that becomes part of my portfolio. Essentially I wind up paying myself the principal plus an interest rate of like 4% or so. Yes, I am paying myself the interest. The repayments come out of my paycheck, I believe out of post-tax dollars. My repayments are $38.91 twice monthly for an original term of five years, the maximum allowed. One more up-side is that this doesn't show up as debt to anyone checking my credit so it doesn't affect my credit score.

There are a number of downsides. First is that it's debt just like any other. It's easier to forget that I have it since it doesn't show up in Mint, or pretty much anywhere. Stealth debt, if you will. While it's cool that I'm paying myself the interest, that also means that I'm not getting appreciation from the market. That can work both ways, though. I think this year has been rather crappy for my funds, so the overall value of my 401k account has stayed pretty flat because of the almost zero volatility of the loan. They also charge a $50 fee to give you the loan (that's where they get ya), along with a yearly $50 fee. And if I quit or am fired, I'd need to pay back the loan immediately or else be subject to income taxes and the 10% early withdrawal penalty.

Read those terms and decide what you think about this "loan" product. Honestly, as debt goes, I think this is one of the more benign versions, albeit a type of debt with a large number of rules and caveats. It feels like making a deal with the devil except you get your soul back afterward and you're pretty sure he's not going to be too much of a dick about it.

Out of the $4200 of the original loan amount, I still have $3660 to pay back. This is the main reason I made a smaller pre-payment than I would have liked for January. I took $700 out of my savings to start a 401k Loan Pre Payment Fund. I'd like to fund this concurrently with paying off my student loans, depending on the progress I'm making toward my end-2013 student loan payoff goal. I'd like to vanquish it some time this year but I'm not willing to commit to it as a formal goal just yet.

I'm not sure that a 401k loan, if its terms are favorable and its use is noble and Mustachian, is unMustachian except inasmuch as debt is unMustachian. That said, it's best to avoid playing with fire if one can help it.

5 comments:

  1. I agree with you on the "use RRSP for home downpayments". In Canada, as a first time home buyer, we can use up to 20k, but it must be put back into the RRSP equally (or faster) over the next 17 years.
    Fast forward 9 years, I'm divorced, no longer have the house, nowhere near as much in RRSP as I had, and still have the liability of paying them back. My own financial plans have changed since I bought that home, and I do regret taking that money out.

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  2. Hey Gwen,

    Whoah, that's a cautionary tale if ever I heard one, and not something I considered. That is a really good point! With debt generally the obligation can stick around much longer than the reason you got it in the first place.

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  3. Mustachian MatthewFebruary 7, 2012 at 4:57 PM

    The other problem you noted in your writeup but didn't call out as a problem is that you're paying back yourself with after-tax money. Therefore you're paying tax twice, once when you pay your loan back and again when you withdraw your money at time of retirement. I used to watch Suze Orman regularly and she used to harp on this one a lot.

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  4. I've thought about that and I don't think it's a gotcha, though if I'm wrong I'd like to know why. Imagine the alternate case: you get to pay back your 401k loan with pre-tax money. Now you paid into the 401k with pre-tax money, got to take the money out and use it without paying taxes, and then repay it with additional pre-tax money. That strikes me as a pretty obvious loophole, no?

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    Replies
    1. I've been considering your comment and I believe you are right. Either you're spending your tax free money (with a 401k loan) and paying it back in with taxes now or your spending after tax money and contributing pre-tax to the 401k, same net result.

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