Q. Dr. Don,
With the terrible rate of return I am currently experiencing with my 401(k), I am wondering if I should be taking loans from the 401(k) to pay off other loans.
As I see it, if my 401(k) loan is at 4.25 percent and my auto loan is at 5 percent, I am experiencing a 9.25 percent return on my 401(k) money. I have not seen a fund in my 401(k) plan making this type of return in 2010. Am I missing something?
-- Rich Repayments
A. Dear Rich,
Your question got me to revisit a Federal Reserve Board working paper by Geng Li and Paul A. Smith, "New Evidence on 401(k) Borrowing and Household Balance Sheets," referenced by David Wessel in his May 29, 2009, Wall Street Journal article, "Rethinking Conventional Wisdom About 401(k) Loans."
In the paper, the authors propose a checklist as to whether a 401(k) loan might be advantageous to an employee, reprised below:
- If you did not borrow from your 401(k), would you borrow that money from some other source (e.g., credit card, auto loan, bank loan, home-equity loan, etc.)?
- Would the after-tax interest rate on the alternative (non-401(k) loan exceed the rate of return you can reasonably expect on your 401(k) account over the loan period?
- Would you be able to make your 401(k) loan payments without reducing your regular 401(k) contributions?
- Are you comfortable with the requirement to repay any outstanding loan balance within 90 days of separating from your employer, or pay income tax and a 10 percent penalty on the outstanding loan?
If the participant can answer "yes" to all four questions, the 401(k) loan could be advantageous to them; otherwise, other options might be better.
