Better to be in debt to yourself or others?

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ChinchillaWhiplash
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Better to be in debt to yourself or others?

Post by ChinchillaWhiplash » Wed May 16, 2018 8:11 am

Would it be better to take a 401k loan, where you pay back interest to your own account to pay down other debt? Other debt would be lower interest things like heloc 5.5% and student loan 4.875%. Would also allow to fully fund solo 401k with employer funding which is > $30k year. Would hate to sell off assets such as TSM fund and have to build it back up, but could build it rather quickly with increased contributions. Currently will have those loans paid off in 3 years and have no other debt. What would be best?

BogleMelon
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Re: Better to be in debt to yourself or others?

Post by BogleMelon » Wed May 16, 2018 8:21 am

Something to keep in mind, with a 401K loan, once you leave the employer you have only 60 days to pay back the entire balance
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bloom2708
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Re: Better to be in debt to yourself or others?

Post by bloom2708 » Wed May 16, 2018 8:34 am

I would use a 401k loan as a last resort. You still owe the money and your 401k investments are not in the market working for you.

If you want to make faster progress on the debt, figure out how to get more intense on the debt.

Read "The Total Money Makeover" by Dave Ramsey. A dollar only can be spent one way. Progress is diluted by trying to do it all. That makes the progress seem slow and you lose steam. Paying off debt is as much tricking yourself as it is using the tools available.
"We are here not to please but to provoke thoughtfulness" Unknown Boglehead

stan1
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Re: Better to be in debt to yourself or others?

Post by stan1 » Wed May 16, 2018 8:37 am

What is the dollar amount of the loans? What is the dollar amount of the 401K and your annual income?

I'd be inclined to focus on paying down the loans and keep the 401K invested and growing most of the time but sometimes on this board people will post a question like this and we come to find out the loan balance is $20K, 401k balance is $1M, and income is $500K.

J Dough
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Re: Better to be in debt to yourself or others?

Post by J Dough » Wed May 16, 2018 8:42 am

This is something I've wondered as well. It sure seems to make sense to pay yourself interest rather than pay another lender, and the savings in interests rates feel like they stack -- if you are paying yourself 5 percent interest and avoiding paying 6 percent interest, isn't that an effective return of 11%? You can't ignore the opportunity cost of having those same funds invested though.

Another factor to keep in mind is loan fees that would eat into potential savings. For my 401k (administered by Fidelity), I can take a loan of up to 50% of the vested balance (up to some limit). For that loan, I would be charged an "Establishment Fee" of $75.00, plus a "Quarterly Maintenance Fee" of $6.25. The interest rate would be 5.75%. Depending on the context and the debt your are substituting, this may be insignificant, but your costs might also be different.

I'm sure there are situations where this could be advantageous, being mindful of employment stability and the additional risks associated with 401k loans. It's going to come down to what you are comfortable with.

bberris
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Re: Better to be in debt to yourself or others?

Post by bberris » Wed May 16, 2018 9:34 am

The 401k loan is not a loan, it is a withdrawal, followed by increased contributions. So you are essentially withdrawing from your 401k to pay off debt; you are deleveraging. That's fine if that is your intention, but always keep in mind what is really going on, not just the words being used.

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Earl Lemongrab
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Re: Better to be in debt to yourself or others?

Post by Earl Lemongrab » Wed May 16, 2018 11:25 am

BogleMelon wrote:
Wed May 16, 2018 8:21 am
Something to keep in mind, with a 401K loan, once you leave the employer you have only 60 days to pay back the entire balance
This is incorrect. For one thing, the law never required this. The plan is allowed to make another arrangement. At Megacorp it just changes from payroll deduction to you repaying directly.

Secondly, the new tax laws state that the soonest the amount due becomes a distribution is the the tax date with extension for the year in which the amount becomes due. So minimum of 8.5 months grace, and up to about 21 months, depending on when things happen.
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delamer
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Re: Better to be in debt to yourself or others?

Post by delamer » Wed May 16, 2018 11:59 am

stan1 wrote:
Wed May 16, 2018 8:37 am
What is the dollar amount of the loans? What is the dollar amount of the 401K and your annual income?

I'd be inclined to focus on paying down the loans and keep the 401K invested and growing most of the time but sometimes on this board people will post a question like this and we come to find out the loan balance is $20K, 401k balance is $1M, and income is $500K.

Completely agree, both with the advice to just pay down the current loans and also that the decision on a 401(k) loan has to be made relative to the amount of the loan and your account balance.

We used a 401(k) loan when the loan amount was 4% of our total retirement accounts. It was just easier than our other loan options at the time.

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whodidntante
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Re: Better to be in debt to yourself or others?

Post by whodidntante » Wed May 16, 2018 12:08 pm

Earl Lemongrab wrote:
Wed May 16, 2018 11:25 am
BogleMelon wrote:
Wed May 16, 2018 8:21 am
Something to keep in mind, with a 401K loan, once you leave the employer you have only 60 days to pay back the entire balance
This is incorrect. For one thing, the law never required this. The plan is allowed to make another arrangement. At Megacorp it just changes from payroll deduction to you repaying directly.

Secondly, the new tax laws state that the soonest the amount due becomes a distribution is the the tax date with extension for the year in which the amount becomes due. So minimum of 8.5 months grace, and up to about 21 months, depending on when things happen.
Not only did BogleMelon post incorrect information, but it's often repeated incorrect information in threads where someone asks about a 401k loan. :oops:

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whodidntante
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Re: Better to be in debt to yourself or others?

Post by whodidntante » Wed May 16, 2018 12:16 pm

I think it's reasonable to take a 401k loan to pay down high interest debt. You are deleveraging and temporarily reducing your exposure to capital markets. The advantage being that you save some money that would otherwise be spent on interest, and you doing so in a tax-efficient way compared to realizing capital gains to pay down the debt. There are negative scenarios that you need to be cognizant of when making the decision:

- The market goes up without you by significantly more than the interest you would have paid (deleveraging risk).
- You default on the loan and have to pay marginal tax rate + a 10% penalty.

Nate79
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Re: Better to be in debt to yourself or others?

Post by Nate79 » Wed May 16, 2018 12:26 pm

Neither. I would get serious about paying off the existing debt by cutting budgets to the bone. Shifting around debt from one pile to the other isn't really doing anything except saving a few pennies yet tricking you into thinking you actually accomplished something.

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9-5 Suited
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Re: Better to be in debt to yourself or others?

Post by 9-5 Suited » Wed May 16, 2018 12:30 pm

J Dough wrote:
Wed May 16, 2018 8:42 am
This is something I've wondered as well. It sure seems to make sense to pay yourself interest rather than pay another lender, and the savings in interests rates feel like they stack -- if you are paying yourself 5 percent interest and avoiding paying 6 percent interest, isn't that an effective return of 11%? You can't ignore the opportunity cost of having those same funds invested though.
You are leaving out the part where the 5% interest you are paying yourself comes out of your own left pocket, so the stacking and "11% return" isn't right. The net effect is you save the 6% interest on the lender debt and the counterveiling cost is the opportunity cost of the money not growing inside your 401K while it is loaned out.

I could pay myself 5% "interest" on loans I give to myself all day long. My net worth will increase by exactly $0.

J Dough
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Re: Better to be in debt to yourself or others?

Post by J Dough » Wed May 16, 2018 12:43 pm

9-5 Suited wrote:
Wed May 16, 2018 12:30 pm
J Dough wrote:
Wed May 16, 2018 8:42 am
This is something I've wondered as well. It sure seems to make sense to pay yourself interest rather than pay another lender, and the savings in interests rates feel like they stack -- if you are paying yourself 5 percent interest and avoiding paying 6 percent interest, isn't that an effective return of 11%? You can't ignore the opportunity cost of having those same funds invested though.
You are leaving out the part where the 5% interest you are paying yourself comes out of your own left pocket, so the stacking and "11% return" isn't right. The net effect is you save the 6% interest on the lender debt and the counterveiling cost is the opportunity cost of the money not growing inside your 401K while it is loaned out.

I could pay myself 5% "interest" on loans I give to myself all day long. My net worth will increase by exactly $0.
I completely agree. I was trying to make the point with the words "seems" and "feel" that it isn't actually stacking an interest rate and that it isn't actually an 11% effective return in my example. Looking back at it, that didn't quite come across in my comment. Thanks for the clarification.

BogleMelon
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Re: Better to be in debt to yourself or others?

Post by BogleMelon » Wed May 16, 2018 12:49 pm

Earl Lemongrab wrote:
Wed May 16, 2018 11:25 am
BogleMelon wrote:
Wed May 16, 2018 8:21 am
Something to keep in mind, with a 401K loan, once you leave the employer you have only 60 days to pay back the entire balance
This is incorrect. For one thing, the law never required this. The plan is allowed to make another arrangement. At Megacorp it just changes from payroll deduction to you repaying directly.

Secondly, the new tax laws state that the soonest the amount due becomes a distribution is the the tax date with extension for the year in which the amount becomes due. So minimum of 8.5 months grace, and up to about 21 months, depending on when things happen.
Thank you Earl for the clarification!
"One of the funny things about stock market, every time one is buying another is selling, and both think they are astute" - William Feather

ChinchillaWhiplash
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Re: Better to be in debt to yourself or others?

Post by ChinchillaWhiplash » Wed May 16, 2018 3:21 pm

401k balance $275k. Heloc $42k and paying $2k month. Student loan $62k and paying $550 month. Mortgage 4.5 fixed, $3868 month. Can only borrow $50k. Think I will continue to throw all I can at the heloc each month and forgo the loan. Paying a minimum of $2k month now and full balance isn't due until 2027. Have 21 months to go if paying $2k. Then going to hit the student loan and pay at least $2500 month. Can do this while maxing out tax advantaged payroll deduction of $18500 a year and HSA at $6900. Leftover funds will be put to Heloc each month to get rid of it as quickly as possible. Being at fed tax rate of 32%, want to take advantage of the tax deferment as much as possible. Once the student loan is paid, will fund the employer side of the 401k and hopefully be able to do a backdoor Roth also. Thanks for the advice. Was thinking it would be a good idea to transfer where the interest payment was going. Forgot about the fees that come with it and don't want to risk taking those $s out of the market :greedy

Chuck
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Re: Better to be in debt to yourself or others?

Post by Chuck » Wed May 16, 2018 3:45 pm

I would just stop contributing to the 401k until the debts are paid off.

ChinchillaWhiplash
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Re: Better to be in debt to yourself or others?

Post by ChinchillaWhiplash » Wed May 16, 2018 4:06 pm

Chuck wrote:
Wed May 16, 2018 3:45 pm
I would just stop contributing to the 401k until the debts are paid off.
Thought about that, but with the new tax laws will lose a bunch of deductions and get killed on taxes for 2018. Have enough itemized deductions that won't take the standard. With the $10k cap on state and property tax and losing the heloc interest deduction, losing at least $10k in deductions. I'm contributing enough to keep it close to the levels we are currently paying.

Chuck
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Re: Better to be in debt to yourself or others?

Post by Chuck » Wed May 16, 2018 4:36 pm

Compare that to what you lose on interest by not doing it.

Spreadsheet both scenarios and see which one makes you end up with more spendable money.

JoeRetire
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Re: Better to be in debt to yourself or others?

Post by JoeRetire » Wed May 16, 2018 5:19 pm

ChinchillaWhiplash wrote:
Wed May 16, 2018 8:11 am
Would it be better to take a 401k loan, where you pay back interest to your own account to pay down other debt? Other debt would be lower interest things like heloc 5.5% and student loan 4.875%. Would also allow to fully fund solo 401k with employer funding which is > $30k year. Would hate to sell off assets such as TSM fund and have to build it back up, but could build it rather quickly with increased contributions. Currently will have those loans paid off in 3 years and have no other debt. What would be best?
Borrowing from your 401k is generally a bad idea.
- generally you can only borrow $50k or 50% of your account balance, whichever is less
- money borrowed from a 401k is no longer in the market, losing valuable compounding time
- paying back money borrowed from a 401k must be done with after-tax money. This is taxed yet again when withdrawn, effectively producing double-taxation. Depding on your tax brackets this could be costly.

You would likely be better off finding another way to pay off your other debt.
Last edited by JoeRetire on Wed May 16, 2018 5:22 pm, edited 1 time in total.

TravelforFun
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Re: Better to be in debt to yourself or others?

Post by TravelforFun » Wed May 16, 2018 5:20 pm

whodidntante wrote:
Wed May 16, 2018 12:16 pm
There are negative scenarios that you need to be cognizant of when making the decision:

- The market goes up without you by significantly more than the interest you would have paid (deleveraging risk).
- You default on the loan and have to pay marginal tax rate + a 10% penalty.
The market could go down as well and that would make borrowing from your 401k a genius move.

TravelforFun

TravelforFun
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Re: Better to be in debt to yourself or others?

Post by TravelforFun » Wed May 16, 2018 5:24 pm

JoeRetire wrote:
Wed May 16, 2018 5:19 pm
- paying back money borrowed from a 401k must be done with after-tax money. This is taxed yet again when withdrawn, effectively producing double-taxation. Depding on your tax brackets this could be costly.
There is no double taxation. Any loan you borrow, you would have to pay it back with after-tax money.

TravelforFun

JoeRetire
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Re: Better to be in debt to yourself or others?

Post by JoeRetire » Wed May 16, 2018 5:26 pm

J Dough wrote:
Wed May 16, 2018 8:42 am
if you are paying yourself 5 percent interest and avoiding paying 6 percent interest, isn't that an effective return of 11%?
If that actually worked you should pay yourself 100% interest - you'd be (effectively) rich!

(If you are both the borrower and the lender, is a higher interest rate good, or bad? Good for the lender, bad for the borrower? Hmm...)

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Yuba
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Re: Better to be in debt to yourself or others?

Post by Yuba » Wed May 16, 2018 5:27 pm

ChinchillaWhiplash wrote:
Wed May 16, 2018 4:06 pm
Chuck wrote:
Wed May 16, 2018 3:45 pm
I would just stop contributing to the 401k until the debts are paid off.
Thought about that, but with the new tax laws will lose a bunch of deductions and get killed on taxes for 2018. Have enough itemized deductions that won't take the standard. With the $10k cap on state and property tax and losing the heloc interest deduction, losing at least $10k in deductions. I'm contributing enough to keep it close to the levels we are currently paying.
You only lose the HELOC deduction if the HELOC loan was not used to pay for a home improvement. If you can attribute the HELOC to an improvement on the property, then it is still tax deductible.

Yuba

JoeRetire
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Re: Better to be in debt to yourself or others?

Post by JoeRetire » Wed May 16, 2018 5:27 pm

TravelforFun wrote:
Wed May 16, 2018 5:24 pm
JoeRetire wrote:
Wed May 16, 2018 5:19 pm
- paying back money borrowed from a 401k must be done with after-tax money. This is taxed yet again when withdrawn, effectively producing double-taxation. Depding on your tax brackets this could be costly.
There is no double taxation. Any loan you borrow, you would have to pay it back with after-tax money.

TravelforFun
Traditional 401ks are funded with pre-tax money. But the 401k loan and interest must be paid with after-tax money. That same money is taxed yet again when you withdraw it during retirement.

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Earl Lemongrab
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Re: Better to be in debt to yourself or others?

Post by Earl Lemongrab » Wed May 16, 2018 6:46 pm

JoeRetire wrote:
Wed May 16, 2018 5:19 pm
Borrowing from your 401k is generally a bad idea.
- generally you can only borrow $50k or 50% of your account balance, whichever is less
- money borrowed from a 401k is no longer in the market, losing valuable compounding time
- paying back money borrowed from a 401k must be done with after-tax money. This is taxed yet again when withdrawn, effectively producing double-taxation. Depding on your tax brackets this could be costly.
A few counters.

Most people have fixed-income in their 401(k). If your loan amount is within the allocation to that, then you can rebalance and consider the loan the fixed income with the interest the earnings.

The double-taxation is a myth. You'd be paying back interest to whomever from after-tax. Your investments would be still be generating earning in the 401(k) and would taxable. It doesn't matter that the earnings came from you.
This week's fortune cookie: "Your financial life will be secure and beneficial." So I got that going for me, which is nice.

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Rainier
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Re: Better to be in debt to yourself or others?

Post by Rainier » Wed May 16, 2018 6:52 pm

What if your 401k was invested in low interest bond funds?

Instead of lending to the government or a company you can lend to yourself and pack more interest into the account.

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