401K loan vs car loan

[Deleted]

A friend is thinking about buying a car and pass the idea thru me.

He has a few issues with his credit now and thinking he might have a problem getting a car loan or if he does it might be at a high interest rate.

He was approved to take out a loan from his 401K to cover the car (minus his deposit).

His 401K loan would be at a interest rate of 4.25% for 5 years and he will pay a maintenance fee of $8.25/quarterly. He said his job his secure and he does see himself with the company for the next 5 years (so getting fired and having to pay the amount back is not an issue, he has been with them for 4 years now).

I think 4.25% sounds pretty good compared to my 6.5% for my car but not sure if I should tell him to go for it or not. What do you guys think?

[Deleted]

tell him to pay cash.

[RoadToRiches]

He said his job his secure and he does see himself with the company for the next 5 years

So did people working at Enron... and Adelphia...and WorldCom.


Taking loan out of 401k for car.. bad idea. Doesn't matter what interest rate is. Car loans are calculated different when it comes to interest.

If he has bad credit, that means he either is not paying his bills on time or is maxed out.

[qofcc]

The 401K loan could be ok as long as he had a way to pay it back if he lost his job, but it won't help rebuild his credit. He should at least look around for auto loans before giving up.

Car loans are calculated different when it comes to interest.

no, they haven't been for many years now.

[phil5185]

I think 4.25% sounds pretty good

After you add in the $165 maintenance fee, it is closer to 5%. But the main issue is that he loses 5 yrs of the power of compounding in the 401k, he will be giving up a large chunk of his balance 30 yrs from now. So he is trading future wealth for instant gratification. And it sounds like he has already done quite of bit of that?

What is wrong with doing some maintenance on the car that he has and keeping it for 5 or 10 more years? (Both of our cars are at 100,000 miles - I expect drive them both for a long time.)

[SVT]

C'mon Phil! How 'bout a new ZR1 Corvette?

[Deleted]

Thanks guys I will let him know.

Phil, his car is quite old (he has been driving it for 6 years now and bough it used) and the reason he is looking into buying another car is because his mechanic told him this was is a money pit.

He is definitely not in the "keeping up with the Jones' club, I can vouch for him.

[RoadToRiches]

Apr 11, 2011 12:11:00 GMT -5 qofcc said:

The 401K loan could be ok as long as he had a way to pay it back if he lost his job, but it won't help rebuild his credit. He should at least look around for auto loans before giving up.

Car loans are calculated different when it comes to interest.

no, they haven't been for many years now.

Can you tell me more?

My interest was already included in my purchase price when I had a car loan.

[phil5185]

buying another car is because his mechanic told him this was is a money pit.

Or - maybe he needs a new mechanic? How many miles on the car?

[qofcc]

But the main issue is that he loses 5 yrs of the power of compounding in the 401k, he will be giving up a large chunk of his balance 30 yrs from now. So he is trading future wealth for instant gratification.

I wouldn't say he's loosing out on 5 years of the power of compounding, he's just locking a portion of his balance in at 4.25% for 5 years. Depending on his investment mix, this may be a higher or lower rate of return than he might have earned otherwise. Since a 401K loan is a maximum of 50% of the balance, then it might make sense to invest the remaining balance more aggressively since that portion is locked into a fixed rate.


Can you tell me more?

My interest was already included in my purchase price when I had a car loan.

This was a regular car loan through a bank in recent memory in the USA? Any lending institution I've ever dealt with amortizes car loans the same as personal loans.

[RoadToRiches]

Yup.. regular car loan for used car at 6%. It was taken out almost 6 years ago. It was NOT a personal loan. It was a CAR loan.

My friend recently took out a CAR loan as well. Calculated the same as my old one.

This is in USA.

[qofcc]

Yup.. regular car loan for used car at 6%. It was taken out almost 6 years ago. It was NOT a personal loan. It was a CAR loan.

My friend recently took out a CAR loan as well. Calculated the same as my old one.

This is in USA.

They told you that the all of the interest was included up front and not amortized over the life of the loan? Are you sure? What bank was this?

[RoadToRiches]

Yup, it was. It was a Dollar Bank.

[qofcc]

Yup, it was. It was a Dollar Bank.

With all due respect, I think you're confused. I looked at their website and they offer auto/boat/rv loans as well as personal loans and home equity loans. They are all regular loans where the interest calculated based on the monthly balance, just like any other bank. You would have received a loan document showing you how much interest you'd pay if you keep the loan to term, but if you make extra payments, the interest is re-calculated.

[phil5185]

www.dollarbank.com/loans/calcPayment.aspx

I, too, looked it up. Dollar Bank amortizes their car loans on a normal schedule.

[RoadToRiches]

Maybe they changed it since I got it?

I am not confused. I know what loan I had.

[jimb]

Apr 11, 2011 15:11:49 GMT -5 RoadToRiches said:

Maybe they changed it since I got it?

I am not confused. I know what loan I had.

As others have said, virtually all lenders except for sleazy buy-here-pay-here dealers and sub-prime lenders create an amortization schedule by computing the interest on the unpaid balance every month.

On most mortgages and car loans, the monthly interest is 1/12 of the unpaid balance regardless of when it's received as long as it is received within the grace period every month. Some lenders may also compute it at 1/360 or 1/365 of the yearly rate, times the number of days in the month. It will average out within a few dollars either way.

Since you don't mention the purchase price or the time, it sounds somewhat like you may have fallen into the trap of negotiating on the payment per month instead of the actual price of the car and the rate of the loan.

What did your paperwork say about the actual loan balance, the rate, the number of payments, and payment per month?

jimb

[jimb]

...But the main issue is that he loses 5 yrs of the power of compounding in the 401k, he will be giving up a large chunk of his balance 30 yrs from now. So he is trading future wealth for instant gratification.

I wouldn't say he's loosing out on 5 years of the power of compounding, he's just locking a portion of his balance in at 4.25% for 5 years. Depending on his investment mix, this may be a higher or lower rate of return than he might have earned otherwise. Since a 401K loan is a maximum of 50% of the balance, then it might make sense to invest the remaining balance more aggressively since that portion is locked into a fixed rate.

He’s also losing the compounding on a big lump sum that would most likely grow a lot more than the interest he’s paying himself back.

True, if you had a working crystal ball to insure that you weren’t going to lose your job, and to know what the market was going to return for the next five years, you might come out ahead.

But you’d almost surely lose if you had even a single good year like 2009, or had a diversified portfolio that had enough bonds and stable value funds to reduce the loss during the market crash of 2008.

Here’s an example to illustrate the problem:

If you borrow $15,000 at 8.% and pay it back in 5 years, the payment is $304.15 per month. The total cost is $18,249 with $3,249 interest.

If you borrow $15,000 at 4.5% from your 401(k) and pay it back in 5 years, the payment is $279.65 per month. The total cost is $16,779 with $1,779 interest.

If you had left the $15,000 alone earning perhaps an average of 8% for the 60 months, it would grow to $22,348.

If your repayments are invested as soon as received --which is not always the case-- then earning the same average of 8% you'd have $20,547 at the end of the 60 months.

So over the 5 years you've lost $1,800 from your 401(k) plan in order to save $1470 in interest on the loan.

If you had 30 more years until retirement, then at an average of 8% earnings the $1800 deficit would cause you to come up short by about $19,684 at retirement time.

At a more conservative 5% earnings after retirement, that $19.7K could have paid an extra $105.67 per month for 30 years before it was all gone. So you've given up a potential of about $38,041 in retirement income in exchange for feeling good about saving $1470 on a debt several decades earlier.

jimb

[JustLurkin]

Apr 11, 2011 10:53:42 GMT -5 RoadToRiches said:

He said his job his secure and he does see himself with the company for the next 5 years

So did people working at Enron... and Adelphia...and WorldCom.

I was outsourced 3 weeks after taking a home loan. Thankfully, I got in while the getting was good and my home has appreciated significantly--not to be said for his auto loan!

[buster]

As the old saying goes...it is never a good idea to take a loan (personal or otherwise) out from your 401k. Jimb gave you the numbers to prove it. Your friend should definitely consider a traditional auto loan through a traditional lender. Has he looked into any credit unions?

[2kids10horses]

Here's something to think about on 401k loans:

When you borrow money from a bank, that interest leaves you, and goes to the bank.

When you borrow from your 401k, you pay your 401k back. The interest you pay on your loan, goes back into your 401k.

So, the question becomes "would you rather pay interest to your banker or to your retirement fund?"

Granted, there are the job stability issues, and all that.

One more thought: how has the 401k been doing? Phil would advise investing in something like SPY, the S&P500 ETF. He maintains that it returns an average of 11% per year.

So, if you take money out of the 401k, you create a receivable in the 401k that earns at 4.5%. You would have earned 11% if invested in SPY. So, the "opportunity cost" of borrowing the money is 6.5% of the amount borrowed.

Now... all that being said... I once borrowed money from my 401k in the year 2000. I believe I had to pay 9% on that money. I borrowed it for a down payment for a rental house. Before that, I was 100% in stocks in my 401k. Well, luckily for me, the stock market crashed! (Let's use "luckily" with a grain of salt... I still had plenty of money invested in the market that declined in value quite dramaticly.) So, I withdrew money at a stock market top. I then repaid my loan with monthly payments of principal and 9% interest. I eventually paid it off early, but for a couple of years when the stock market was crashing, the value of my 401k held steadier because I had reduced my exposure to stocks, and was paying it back with my interest payments. In fact, the payments I made would purchase more shares, and when the market did finally start to recover, I had bought back in at low prices.

It was a somewhat perverted form of market timing that worked out well for me! Whereas a lot of my peers at work were bemoaning their stock market losses in their 401k, my losses were much less.

I mention this because it's not always black and white.

Oh, and the rental house I bought... well, I can't remember exactly which one that was...,it provides steady income for me now, and I'm retired, and so, I think it was the right thing for me to do.

Whether it's appropriate to use that money for a current expense like buying a car... I dunno. You see, I "rented" my money to invest in something that would make money. Not for a current living expense.

[azphx1972]

In general 401k loans are a bad idea. In addition to the reasons already mentioned, here are some more:

www.themoneyalert.com/401kloan.html

[2kids10horses]

az,

That's a good link, and it does accurately describe a 401k loan. In my case, I was still able to make contributions to my plan even though I had borrowed against it. So that "penalty" didn't apply. Duh, obviously, your "take home" pay will be reduced. But, if you take out a regular loan, you would have to spend some of your "take home pay" to pay the loan anyway, so that is not a true disadvantage.

I still think the primary advantage is the interest you pay is going back to yourself, rather than going to a bank, if you are still allowed to contribute to your plan.

The REAL problem is a LOT of people never repay the 401k, and then it's treated as a withdrawal! Then the funds are taxed, and the IRS imposes a 10% penalty for the early withdrawal. THAT is the real issue. If you pay back on schedule or before, then there is no penalty.

[txengineer]

It really depends on how your 401k is setup. My 401k plan allows me to borrow up to 50% of my balance without taking out any portion of my investment, in other words, my investment stays invested the entire time. The interest I pay on the 401k loan, however, is not paid to my 401k (because nothing is taken out of my 401k), but paid to the cash fund the company administers and counted as fund income which will be shared by all 401k accounts invested in the cash fund.

[azphx1972]

Personally I think it's best to not think of your 401k as an ATM, because it raises temptations to do things with it other than its intended purpose (retirement). I know of many people that rather than roll their 401ks into IRAs or a new employer's 401k plan, cashed them out and used the funds to pay down debt or buy stuff. If they had maintained the proper mindset that 401ks are to be used for retirement only, they may not have made those poor financial decisions.