Question from Ryan:
I’m an avid reader of your blog and enjoy it very much. I recently read this article, and I’m considering tapping my 401K. I did not see a discussion about this on your blog and thought you might find it interesting, also your thoughts on this!
The question Ryan asked me is a very typical one. Very often we find ourselves in a position when we need to make a very tough decision. Should Ryan take out a 401k loan if he’s mired in credit card debt? On one hand it makes perfect sense since the interest he’ll be paying on the loan is a lot lower than the interest he has to pay on his credit cards. On the other hand, tapping into his retirement savings could be a very daunting task. To make a decision like this, we would need to use a system that can objectively indicate the best possible solution. Using Ryan’s case as an example, I’ll explain what I would do if I was in Ryan’s shoes.
Unfortunately, I couldn’t answer Ryan’s question immediately after he sent me his email. I couldn’t do it for two reasons. First, I didn’t know much about 401k loans, and second, I quickly realized that whether you should take a loan or not depends on individual circumstances. After doing some research on 401k loans, I discovered the following information:
The pros of 401k loan:
- Low interest. The interest is usually equal to the prime rate plus 1 or 2 percent.
- The interest you pay on the loan goes towards your 401k account balance.
- You don’t have to pay taxes on the interest until retirement.
The cons of 401k loan:
- Not all companies allow 401k loans.
- Some plans don’t allow you to make new contributions to the account until you fully pay off the loan.
- If you quit your job, or get fired before you repay the loan, you have 60 days to repay the loan in full. If you can’t manage that, then it’s classified as a 401(k) withdrawal. The unpaid loan balance will be taxed as regular income, and on top of that, you have to pay an extra 10 percent penalty.
Let’s assume I was reckless enough to accumulate $50,000 in credit card debt. My current annual interest rate on the debt is 14.0%, and the total interest I would have to pay over the next 5 years is $18,527.80 (according to this calculator). If I took out a 401k loan for $50,000 at 4.25% interest to pay off my credit card debt, I would only need to pay $5479.00 in interest according to the same calculator. That means I would save $13,048.80 in interest payments. However, the total savings would be $18,527,80 because the interest I would pay on my 401k loan would still go towards my 401k account balance rather than to the credit card company. Technically, I’m saving all the interest that I would have to pay on the credit card! Should I take out the loan? Normally, the majority of people would say “yes!”. However, I can only answer this question after taking into account all costs, including opportunity costs. I could do this by creating what economists call a decision tree.
A decision tree is basically a technique economists use to approximate outcomes based on their probabilities. For example, even though we know that I’ll save $18,527,80 if I take out a 401k loan, we also know that some companies do not allow contributions to the 401k account until the loan is fully paid off. If my employer’s matching contribution is 1 to 1, that is for every dollar I contribute to my plan my employer kicks in an additional dollar, and my yearly contributions have been 10% of my $50,000 salary, I would lose $22,500 (25,000 * 90% probability) in “free” money over the course of 5 years that I would have gotten otherwise from my employer had I not taken the 401k loan! Now that loan doesn’t look like such a great deal, does it? Even if my employer allowed contributions while I was making loan payments, I might still be tempted to contribute less to my 401k account because of the loan payments, thus reducing my long-term retirement account balance. On top of that, we also know from the “cons” listed above that if I lost my job for whatever reason, I would have to pay off the entire loan balance within the next 60 days or otherwise I would have to pay the tax plus 10% penalty. That would potentially make me lose even more money! Can I know how much exactly? I would say yes, if I know what the probability is of me losing the job. Let’s say the probability is 10%. Relying on this estimate, I would make my calculations:
[$50,000 (loan amount) * 0.25 (tax) + 5,000 (10% penalty)] * 0.10 (probability of me losing the job) = $1,750 in additional loss!
By adding up the money I would save ($18,527. 80) to the money I would lose (-$24,250), I can conclude that I would lose $5,722.20 if I took out the loan. Here’s how my complete decision tree would look like:
This is a quick sketch of a decision tree for this specific example. In Ryan’s case, he would have to create a decision tree for his specific circumstances. I believe the decision tree approach is the most accurate way to come up with ultimate decision.
If you find it difficult to create a tree, consult a financial professional who can do it for you. Also, if you find any inaccuracies in the post, please leave your comment below. I hope you found this post informative. Thanks for reading.