SMI Visitor's Blog       

Welcome to the SMI Visitor's Blog where you'll find selected excerpts from our Member's Blog, plus occasional posts created especially for our visitors.

For SMI Web Members, click here to go to the SMI Member Blog.

« Blog Home

401(k) loans and 2nd mortgages

Shocking: almost 30% of 401(k) savers have a 401(k) loan outstanding.

I'm speculating here, but I suspect the type of faulty analysis presented in this article is one reason that might be the case:

What is more, with interest rates so low and the stock market volatile, a 401(k) loan can offer a decent rate of return. An investor who took a $25,000 loan five years ago at 6% interest would have paid himself about $4,000 in interest about the same return as if he had invested in a Standard & Poor's 500 stock index fund for the same period, without the crash-induced stress.

For borrowers who use the money to pay off high-interest debt, the effective return can be greater, thanks to the savings they get by replacing it with the lower-interest loan.

Wrong. Sure, the balance in the 401(k) might be the same whether the $4,000 in interest came from the borrower's checking account vs. appreciation in the stock market. But their overall financial condition isn't the same.

In the case of the non-loan, their checking account is untouched, plus they've gained $4,000 in appreciation within their 401(k). In contrast, with the 401(k) loan, their 401(k) balance is the same, but their checking account is $4,000 lower due to the interest they've had to pay into their 401(k) plan. So in total they are $4,000 poorer!

Naturally, they got the $4,000 loan in the first place, which theoretically offsets the $4,000 hole in their checking account. But in too many cases, that money is spent on stuff the person wouldn't otherwise borrow for if they realized that borrowing from their 401(k) really isn't much different than borrowing the money from the bank. Too often, articles like this one make it seem like 401(k) loans offer something for nothing. Not so.

The idea that borrowing from yourself is somehow free is an illusion. As we pointed out in early 2009, borrowing from a 401(k) might be a reasonable idea if you are absolutely going to have to borrow anyway. Otherwise, it's usually a bad idea.

Related: those with 2nd mortgages are more than twice as likely to owe more than their house is worth than those without 2nd mortgages (38% vs. 18%).

What do these items have in common? Both 401(k) plans and home equity used to be regarded by most people as more or less "untouchable" savings. Somewhere along the line that changed and many people started using these reserves to supplement income. That has proven to be a big mistake.

Powered by Movable Type  |   Subscribe  |   Email Updates