401k Loan vs. Second Mortgage
by Gary Foreman
Description: Looking at the pro's and con's of taking out a 401k loan vs. a second mortgage on your home.
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Dear Dollar Stretcher,
I am a recent grad from business school and I have just started a new
job as a loan officer. I am writing you to ask a quick question. I am
curious if it makes sense to repay a 401k loan with a 2nd mortgage loan?
The interest rate on the 401k loan is 8%, the 2nd mtg is 10%, and we
are talking about a $50k loan size.
Andrew
Andrew asks a question that's becoming more and more common. In the old
days a loan matched the item being financed. If you were borrowing to
buy a car you took out an auto loan. But today our borrowing options
have increased. You can borrow money against your home and use it to buy a
new car. Or in Andrew's case, he can use it to pay off a previously
arranged loan from his 401k plan.
But is that a good idea? There's probably no single right answer. At
least not without being able to see into the future. But you can look at
the important elements of each type of loan to see which loan is likely
to be best for your situation.
We'll begin that process by comparing the similarities and differences
of the two types of borrowing.
The first thing that most of us think about is the interest rate. Only
natural. It's a major part of any loan. Often you can just compare the
rates and the lower one wins.
But in this case there are some tax consequences involved. The 401k
loan is not deductible from federal income taxes. The second mortgage
probably is. If so, that would reduce the cost of the debt.
Figuring how much seems complicated, but really is fairly easy. The
after-tax interest rate is the stated rate times one minus your individual
tax rate. So the cost of the second mortgage if Andrew were in the 18%
bracket would be 10% x (1 - .18) or 8.2%.
So the cost to borrow is pretty much the same for the 401k or second
mortgage. At least today it is. But, is either loan variable? The 401k
loan is probably fixed, but the interest rate on the second mortgage
could be variable and change during the life of the loan.
A variable loan offers both opportunity and risk for the borrower. The
opportunity is that it features a lower rate of interest than would
otherwise be available. That means lower payments. The risk is that the
rate could increase making payments painful if not impossible.
The next thing to consider is how each loan is secured. The second
mortgage is obvious. You don't pay, you could get kicked out of your house.
The 401k is a little more subtle. If you don't repay the loan amount is
added to your taxable income and a 10% penalty is applied. So if Andrew
were in the 18% tax bracket, he'd have to pay the IRS 28% of what was
owed and not repaid to his 401k. Additionally, his 401k plan would be
smaller when he needed it at retirement.
In this case both loans have a set term. You can look at the loan and
know when you'll be finished repaying it. That's not always the case.
Some loans (like credit cards) are open accounts that may never mature.
However, the length of these two loans is very different. The 401k loan
is probably much shorter than the second mortgage. That's important for
two reasons. First, the mortgage loan will have lower monthly payments.
But, it also means that Andrew will pay much more in interest over the
entire life of the mortgage.
Those are the big issues to consider: interest rate, fixed or variable,
secured or unsecured, and term of the loan. But, there are some other
things to think about before making a decision.
One advantage to the 401k loan is that repayment is fairly painless.
It's probably automatically deducted from Andrew's paycheck. That's a
great way to avoid missing payments or being late.
The second mortgage has a couple of quirks that might be important to
him. First, if he decided to sell the house the mortgage will be
completely paid from the sale proceeds. That could limit the amount of money
he has available to buy a new home.
Secondly, the second mortgage might require him to set up an escrow
account for taxes and insurance. Or, it might require that he carry an
expensive private mortgage insurance policy.
Before making a final decision Andrew will want to study the details of
both potential loans. That means reading loan agreements. He could find
something that's important to his situation.
Andrew can use this framework to compare any two loans. It's simply a
matter of doing a little research on how a loan works and then comparing
the different elements to see which type of loan best meets your needs.
Gary Foreman is a former financial planner who currently edits The
Dollar
Stretcher.com. If you'd like to stretch your day or your dollar visit
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Dollar Stretcher.com. You'll find hundreds of articles to help you
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