The common advice we get is that you should never take a 401k loan. They give multiple reasons but the basic point is that you stand to lose a ton of money (from penalties if you cannot pay it all back to lost gains because you aren’t in the rallies). However, my question is there ever a good reason to take a 401k loan? In my situation I believe taking the loan was a good idea.
So in back in September we noticed that the rates on mortgages had continued to drop from our previous refinance a couple years ago and decided to look into refinancing again. Of course wanted to be out of all debt as soon as possible we started looking into what would be needed to not only refinance to a lower rate but also a shorter term. Our current mortgage was a 30-year fixed (28.25 years remaining) FHA loan at a rate of 4.5%. The other thing we wanted to get rid of was the FHA loan’s Mortgage Insurance Premium (MIP) that was costing us around $160 a month.
The first issue we ran into is getting our mortgage down to the 80% LTV needed to avoid Mortgage Insurance. We knew that the house had appreciated a bit and using both Bank of America’s house worth estimator and Zillow’s Zestimate we found that we would need to bring to closing 5-16% of the new mortgage. The other problem was reducing the loan length would potentially increase our mortgage payment and we needed to adjust our monthly budget to account for that.
How it all went down
So knowing that we would need at least 5% and the stock market doing so well we were able to sell off some stock to get about 6% after removing some for the capital gains tax. We then went around to all the financing institutions (BECU, Well Fargo, Bank of America, Tech First, ING, RMC Vanguard, etc.) asking for their quotes. We also did them all on the same day as that is important not only to get all the inquiries marked as a single inquiry on our credit report, but to make sure the rates were comparable as each day the mortgage rate changes. In the end we went with RMC Vanguard (found through Costco’s Home Mortgage Program) since they had the best rate. They ordered up the Home Appraisal and we waited to find out the results. A week later the appraiser came by and low and behold the value almost matched Zillow’s exactly which meant that we needed to raise the entire 16%.
Note: The Appraiser did mention that if one of the two additional houses on market sold then the value of our house would jump up another 20-40k in value, but they had already been on the market for quite some time.
So in addition to the 6% gain in sale we did have another 5% in savings (Mostly E-Fund related (4 months of mortgage payments in one account and 12 months of non-mortgage living expenses in the other account). This left the problem was coming up with an additional 5%. The bank offered to finance that 5% as a second mortgage with a 6.5% interest rate but then I noticed that my 401k has an option to take a loan out. Hearing all the bad things about 401k loans (relatives of mine who used one but wasn’t able to pay it all back so got hit with penalties, lost gains, missing the employer match, etc.) I was very cautious to take one out. However after much deliberation we decided to take the loan and cover the rest of the closing costs. Here is how we determined to take the loan.
First we reviewed next year’s budget to see what we could cut back. Already we were saving about 0.4% (not including 401k contributions) a month towards various goals that could take a break or reduction for a year. So cutting additional spending would allow us to be able to repay the 401k loan in a single year while still being able to contribute (thus not losing the employer matching).
Second, the rate on the 401k loan was the same as our previous mortgage so we wouldn’t be trading cheaper money for more expensive money.
Third, with the duration of the loan only being a single year I doubted the economy would move enough to amazingly beat the 4.5% return on the loan. Which happened to be quite fortunate as after taking the loan the stock market faltered and the remaining 401k balance went from 18% PROR (Personal Rate of Return) to 12% PROR for the year.
And forth, we wanted to avoid having to borrow such a large sum from relatives which might strain our relationships with them.
So was this a good reason to take a 401k loan? Well I am only a quarter of the way through my repayment plan but so far we have been handling the situation quite well. It also has given us insight into what in our budget was really just fluff and could be reduced if need be. Perhaps you can give your insight in the comment section.