An acquaintance recently mentioned something that got me
thinking. Married, with an adult son who
has special needs. Her husband of 20+
years is, unfortunately, disabled. She
is the sole bread winner in the household, but her salary affords a
comfortable, but not extravagant, lifestyle.
The downsides are that her position requires a lot of travel
in the region, and work at all hours. In
fact, she told me it’s not uncommon for her to be emailing her team at midnight and then have a conference call at 7:30 the next morning.
As the sole breadwinner, her family has to be careful with
money, though it’s not a day to day concern.
She recently took a loan from her 401(k) to pay off other debt – a car
loan I believe. Her rationale – it’s good
because the interest you pay on the 401(k) loan is really paying yourself.
True enough.
This is a fairly common strategy - trading or swapping one loan for another for many people. And it’s really no different in concept than
refinancing your mortgage or getting a home equity loan to consolidate debt.
Today, this strategy is unfortunately common for some
people, as this article discusses.
The article states that the average credit card balance is
over $8,000 for those over 50, and around $6,000 for those under 50. Let’s just use an average of $7,000 for
simplicity’s sake.
Bankrate.com shows that the average rate on a new credit
card today is about 16% (again, using round numbers for simplicity). And the Prime Rate – typically charged on
401(k) loans is 3.25%.
So let’s suppose that she carried that $7,000 and just pay
the interest only. What would the
results be?
Credit card - $7,000 times 16% = $1,120 interest paid per
year.
401(k) - $7,000 times 3.25% = $227.50 interest paid per
year.
Savings? $892.50 or
almost $900!
On the surface, this looks like a slam dunk.
But wait, there’s more. Did she actually save?
Well, what is true is that by doing this swap, she would pay
less in interest. But did she actually save
it?
If she’s like most people, probably not. Instead, she probably spent the money you
“saved”. Yes, I’m in that category
myself.
To benefit from this long term, she could raise her 401(k)
contributions by the $900 per year, or $75/month. But did she?
Probably not.
What’s the downside of this strategy, because it still looks
pretty good to do this swap?
Well, for one, the money is “withdrawn” (in the form of a
loan) from the 401(k), which means she’s missing out on any gains for that
money. For example, if the investments
in her retirement account earned 7% (hypothetically), she missed out on 3.75%
(7% minus 3.25% loan rate) of gains for that money for the loan. She’s locked in the return on her loan at
3.25% in this example.
Doesn’t sound like much?
Well, that $7,000 missing out 3.75% gains per year for the next 20 years
is equal to $14,600!
Aside from lost potential gains, she’s also paying more in
taxes. Remember that the money for the
loan was contributed pre-tax in a traditional 401(k). And taking out the loan is a non-taxable
event, so no problem there.
Let’s consider the interest paid. Interest is paid from after-tax dollars. If she’s in the 25% tax bracket, to pay $1 in
interest requires $1.33 in pre-tax income.
Remember, the interest is paid from take home pay, which is after taxes. (Even if the loan payment is automatically deducted from a
pay check, it is still with after tax dollars.
It would no different than having to write out a check each month to
make the loan payments.)
That interest is added to the 401(k) balance, so upon
withdrawal, she pays taxes on that money again!!! So that dollar of interest said paid cost $0.33 in the
beginning, and another $0.25 at withdrawal.
Going back to the $7,000 loan example, what does that one
year’s of interest at $227.50 really cost?
Well, paying that interest really took $303.33, or $75.83
extra in taxes.
Then taking out that $227.50 at retirement time costs
another $56.88 in taxes.
So that $227.50 in interest she paid herself really cost a
total of $360.21 per year!
What do you think of her strategy now? Have you used your retirement account to pay
off a loan? What did you do with the
money saved? How much did it really cost
you?
