Posts Tagged ‘Loan’

Results of the 401k Loan

So as I mentioned from the previous post A Good Reason to take a 401k Loan I took a 401k loan for 1 year to refinance my mortgage. I was able to lower the mortgage from 4.5% to 2.5% and the term from 30 to 15 years. This left the monthly mortgage payment at roughly the same amount as before but it will save about 150k in interest over the life of the loan. So from the mortgage side, yes this was worth it.
But the real question is, was the 401k loan worth it? That takes a bit more investigation since I could have sold off additional investments, just waited until I saved up enough or used a Peer-to-Peer Loan or Second Mortgage to cover the rest.
NOTE: I actually paid off the 401k loan in 6 months instead of a year so these analysis will only cover that period

Selling off investments

If I had decided to go with the selling of investments I would have incurred the short term capital gains taxes which would be 25%. So I would have to sell 133% of the lacking funds to cover taxes as well (133% * 75% = 100%). In addition I would have missed on those investments a 20% gain which means this move effectively costs 160% of the needed cash. This results in a “loan” APR of 156%.This would have been the most expensive option… well payday loans might have been more expensive.

Saving up the cash

This would have delayed the refinance by 6 months so looking at the historical rates the best rate around that time would have been 3%. Not too bad, just a 0.5% higher though that means that I would lock in about 21% more interest paid over the life of the loan. That seems like a lot but that amount in interest was only 60% of what I was borrowing from the 401k over 15 years which results in an “loan” APR 3.2%.

Home Equity/Peer-to-Peer Loan

We could have also gotten a 2nd mortgage at the rate of 5% to cover the lacking amount however that would have resulted in a loan with the APR of 5.05%

401k Loan

Minus the $45 in fees, all interest was paid into the account resulting in a 11.4% gain over the period versus the 11% gain for the market. I was also able contribute to the 401k while having the loan thus I didn’t lose the employer match. So due to taking out the loan before the market went down (which was pure luck) and repaying the loan as the markets climbed I effectively got to borrow the money for free. The effective “loan” APR is -6.9%.

So in this case everything worked out beautifully for the 401k loan. It not only was not a disaster, but actually the best choice I could have made. So to wrap it up, yes usually 401k loans are horrible, but there are real life examples of when it pays off nicely. Just remember to keep the term as short as possible and continue to contribute to the 401k during the loan.

What do you think? Was there another option that I overlooked? Do you disagree with my calculations? Leave a comment below.

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A Good Reason to take a 401k Loan?

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.

Backstory

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.

Issues

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.

Final Answer

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.