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401k loan...need some boglehead advice!

Posted: Sun Jul 10, 2016 7:14 pm
by scarabrad
Hey folks,

Would love some input on the whole concept of 401k loans. I am having a hard time deciphering why these are generally frowned upon and would love to hear some feedback.

Scenario:

The last time the markets were at an all time high, I wanted to cash in some chips, to the tune of $25,000 out of my S&P index fund in my company 401k. I sold $25,000 worth of shares and took that 25k out as a loan against my 401k balance to do a modest kitchen remodel. 5 year loans at 3.75% (roughly). Lo and behold, the market gyrated but ended up heading down a fair amount after I took the loan. Thus, each of my every-other-week payments on the loan through payroll deduction was dollar-cost-averaged back into the fund at lower prices. In addition, by paying myself interest out of my salary, are I not, in effect, sheltering more away in a tax advantaged account than I normally could otherwise because those interest payments are in addition to the $18,500 max I can put away per year?

When the market had some very rough days in January, I paid back larger chunks of principal to bring the loan balance down and I am now about to pay the whole thing off, now that the specter of rising rates has seemed to pass. In fact, I'd like to take out a larger loan of say $40k to do a bathroom remodel, again, cashing in my chips while the market is hitting fresh new highs. If it goes higher, I'll still have skin in the game. If it goes lower, I'll be purchasing shares of the fund at a lower price. If it really tanks, I'll plow larger amounts of principal back into the market to take advantage of any swoons.

Given this overall philosophy, I think I have convinced myself that a 401k loan may not be such a bad idea, but I would love to hear from my more erudite bogleheads as to why my thinking might be faulty. I do know that I could get a HELOC, Home equity loan or just use cash to pay for a remodel (all of which are options), but it's the part about taking advantage of some pretty heady gains in the market lately, locking those in and having flexibility to pay back the loan more aggressively were the market to correct somewhat that makes this particular scenario compelling to me.

Thanks, in advance, for your input. Such an invaluable resource...I've got my 15 and 18 year olds perusing it, as well!

SR

Re: 401k loan...need some boglehead advice!

Posted: Sun Jul 10, 2016 8:53 pm
by VoiceOfReason
scarabrad wrote:Hey folks,

Would love some input on the whole concept of 401k loans. I am having a hard time deciphering why these are generally frowned upon and would love to hear some feedback.

Scenario:

The last time the markets were at an all time high, I wanted to cash in some chips, to the tune of $25,000 out of my S&P index fund in my company 401k. I sold $25,000 worth of shares and took that 25k out as a loan against my 401k balance to do a modest kitchen remodel. 5 year loans at 3.75% (roughly). Lo and behold, the market gyrated but ended up heading down a fair amount after I took the loan. Thus, each of my every-other-week payments on the loan through payroll deduction was dollar-cost-averaged back into the fund at lower prices. In addition, by paying myself interest out of my salary, are I not, in effect, sheltering more away in a tax advantaged account than I normally could otherwise because those interest payments are in addition to the $18,500 max I can put away per year?

When the market had some very rough days in January, I paid back larger chunks of principal to bring the loan balance down and I am now about to pay the whole thing off, now that the specter of rising rates has seemed to pass. In fact, I'd like to take out a larger loan of say $40k to do a bathroom remodel, again, cashing in my chips while the market is hitting fresh new highs. If it goes higher, I'll still have skin in the game. If it goes lower, I'll be purchasing shares of the fund at a lower price. If it really tanks, I'll plow larger amounts of principal back into the market to take advantage of any swoons.

Given this overall philosophy, I think I have convinced myself that a 401k loan may not be such a bad idea, but I would love to hear from my more erudite bogleheads as to why my thinking might be faulty. I do know that I could get a HELOC, Home equity loan or just use cash to pay for a remodel (all of which are options), but it's the part about taking advantage of some pretty heady gains in the market lately, locking those in and having flexibility to pay back the loan more aggressively were the market to correct somewhat that makes this particular scenario compelling to me.

Thanks, in advance, for your input. Such an invaluable resource...I've got my 15 and 18 year olds perusing it, as well!

SR

The truth is you are 100% correct in your assessment.

All financial advice needs to be qualified with some version of "individual circumstances may vary". You prove that point.

The reason most people recommend against 401k loans is because most people that turn to 401k loans do so out of desperation, not strategy.

I've been convinced, just like you, that in down years in the market a 401k loan is the best possible thing you could have done.

If the risks of job loss, repayment terms, and other potential restrictions are negligible, then you are spot on IMO.

Re: 401k loan...need some boglehead advice!

Posted: Sun Jul 10, 2016 9:35 pm
by livesoft
We (my spouse) had a 401(k) loan in order to invest in a 529 plan. When the money was in the 401(k) it was invested in a bond fund. Then the money was essentially moved to a bond fund in a 529 plan. But the expense ratio was way less and the gains were tax-free.

The risk with a 401(k) loan is that the loan can be called and if you cannot pay it off in full, there are penalties, tax consequences, and you lose the tax-deferring for retirement. Indeed, my spouse's employer was sold and her 401(k) loan was called. We had to find money to pay off the loan or end up paying the 10% penalty and having the loan count as income.

Also note that the loan to you is like that 401(k) money being invested in a bond fund. You were fortunate that your interest seemed to give you a better return than a stock fund, but that won't always happen.

Re: 401k loan...need some boglehead advice!

Posted: Sun Jul 10, 2016 9:44 pm
by Toons
"or just use cash to pay for a remodel"

That is exactly what I would do.

I never did use the 401k for loans.
I set it up for retirement funds, and
that is how I treated it.(Untouched)
Tax deferred compounding,no matter
"where the market is". :happy

Re: 401k loan...need some boglehead advice!

Posted: Sun Jul 10, 2016 10:42 pm
by Watty
scarabrad wrote:I am having a hard time deciphering why these are generally frowned upon and would love to hear some feedback.

..I've got my 15 and 18 year olds perusing it, as well!
Hi Gang,

A quick google found this about 401k loans

http://www.investopedia.com/articles/re ... ns401k.asp

In addition the risk that any loan has a 401k loan has a huge risk that if you get laid off or find a great new job and need to leave your current job that you usually have to pay the loan back in a very short period of time. If you can't pay it back then you will be charged penalties, taxes, and taxes on the penalties that can cost you half of the 401k loan amount.

Except for that the 401k loan has many of the same attributes of other loans like credit cards, car loans, house loans, student loans, etc.

There are a couple of problems with trying to use the 401k loan like it was explained.

1) It requires timing the market both when you get in and out of the market. That is pretty much impossible to do over the long term and if someone that could do that would quickly be wealthy and working on wall street making millions of dollars a year. You would not even have to be 100% accurate with your market timing. Just by random chance you might be right 50% of the time. If you were skilled enough to be right 60% of the time you could make millions by buying options.

2) If you wanted to be in or out of the stock market there is no need to take out a 401k loan. All 401k plans have multiple options so that you could just move the money around within the 401k to are invested in what you think will be a safer investment.

3) The interest paid on the 401k loan is pretty low so it really does not add very much to the 401k balance.

4) You can do some stock markets trades and make 15% over a year and feel like you have done well. The problem is that if you had just stuck with a generic investing plan you might have made 20%. Since the financial crisis caused the stock markets to hit lows in 2008 and it has soared since then so having done well over the last 8 years does not mean that you have actually beaten the stock market. The mathematics involved with trying to figure out the relative performance of a 401k with and without a loan with periodic repayments over several years gets very involved real fast. There were famous best selling books about an investing group called the Beardstown Ladies(Google this) that had an investing method that performed really well. It took several years but someone finally saw that their math was incorrect and that they had actually under-performed the stock market.

That isn't to say that the 401k loans that were talked about might not have worked out well, it is just that there is a lot of risk in doing 401k loans like that and sooner or later you could be burned either by mistiming the transactions or having to unexpectedly repay the loan in a hurry.

A better way to get the kids a good head start on investing would be to get them a copy of the Bogleheads Guide to Investing about the time they start working full time.