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Reader-Submitted Question of the Day – Day 3
By JLP | May 1, 2008
Here is today’s Question of the Day. It seems long but that’s only because I needed additional information from the reader. It’s an excellent question.
This year I started to get myself in order – living within my means and debt free. The last part I am working on.
I have paid off my 2 credit cards. I have 3k left on my car – will have that paid off within 2.5 months. But I have a decision to make – and need your help. What to pay off next?
My last outstanding debts are: a student loan and debts to myself (I borrowed against my 401k – yes i know – never again). Which should I pay off first? The loan against the 401k or the student loan? The interest rate is higher on the 401 k loan but it seems more prudent to payoff a creditor instead?
Any thoughts you have would be great.
-TM
I then followed up with TM to get the following information:
1. How much do you owe on your student loans and your 401(k) loan?
Student loan: $23,257.39 and 401k loan: $24,093
2. What is the interest rate on your student loan?
3.5%
3. Does the interest rate on your 401(k) go to you? I know with most 401(k) loans, borrowers are essentially paying themselves back with interest, which means the money and the interest is yours.
Paid back to me.
4. How much money will be available (including what you are currently paying now) to pay towards these loans once everything else is paid off?
I pay $170 on the student loan now and will be able to add $500. For the 401 k loan…I now pay a total of $300 – but to pay it off (they require a “lump sum” payoff) so will have to funnel the extra to a savings account until the total is reached – then pay it off in lump sums….and the 401 k loan is technically 3 smaller loans: $4,117, $10,027 and $9,948.
I could technically put more back…but I am trying to also save to buy some land – it is one of my long term dreams. To buy the land in full and then to start saving to build a house – it will be my dream home.
My Thoughts
The risk of 401(k) loans (other than losing out on the growth of the money) is that IF this person were to quit their job they would have to pay back the entire amount of the loans. Otherwise the loans will be considered a withdrawal and they will have to pay taxes on the amounts outstanding along with a 10% penalty. That’s not a good option. If their employment is safe, then this is less of a worry. But, you never know.
I failed to ask this person if they had an adequate emergency fund. If not, I think I would make building up an emergency fund my first priority. The interest rate on the student loan is pretty low so I see no need to rush to pay it off as long as there are other needs to be addressed.
If it were me I think I would sock away any excess money into a savings account earmarked to pay back the 401(k) loans and take my time paying back the student loans. I would also check with either the HR department or the 401(k) administrator to see if I could increase the 401(k) loan payments without making lump sum payments. I know my wife’s 401(k) just started offering an option to pay extra towards 401(k) loans. It might be worth looking into.
Finally, please don’t borrow from your 401(k) again.
Now it’s your turn to weigh in.
Topics: Question of the Day | 11 Comments »
May 1st, 2008 at 10:35 am
there are numerous sites explaining the pros and cons of 401k loan, so i won’t rehash them; however, when you are comparing the interest rates, you have to include a three-fold wammy you are probably taking by not paying off the 401k loan first, which in real terms dramatically increases the effective interest rate you are paying for the 401k loan vice the student loan.
First, the 401k money is no longer tax advantaged (i.e. you are having to pay off the loan with after tax money, whereas if you pay it off, then it becomes tax deferred); no contributions = no match; student loan money won’t ever appreciate, whereas 401k money historically will. add those three things in and the decision should be really easy as to what to pay off first. To top things off, your student loan is very low (hopefully it is fixed, if not you might want to refinance to fixed). you also have to consider that 401k loans have a 5 year term for repayment, and the student loan probably has a longer term.
i will echo that TM should establish an emergency fund first before or in conjunction with adding additional payment towards the 401k loan. there is nothing mentioned about why a 401k loan was taken out, but if it was used to fund an emergency then it would appear TM’s fundamentals weren’t in place to begin with. so TM should have more than just a repayment focus in order to get back on financial track. TM is getting there, but seems to need an overall financial plan. this would include a savings plan (like an emergency fund) in addition to a repayment plan. TM is still in good shape, because TM should have only been able to borrow 50% of vested amount which indicates that TM still has at least around $25k still left in the 401k, so all isn’t bad. TM could also invest in ira’s to offset some of the tax disadvantages of the 401k, but would have to crunch numbers to see if this would be worthwhile. my guess is no, but we don’t know the interest rate of the 401k loan.
May 1st, 2008 at 10:37 am
I would definitely go after the 401(k) loans first. If possible, pay off each of the three loans separately, from smallest to largest. Is the extra $500 you can use before or after you kill the car loan? If before, then add the car payment, as well. Be really careful not to let the credit cards get out of hand in the meantime.
May 1st, 2008 at 10:37 am
i meant to say “…offset some of the tax disadvantages of the 401k loan”
May 1st, 2008 at 10:49 am
I left out the fact that you pay back a 401(k) loan with after-tax dollars, which definitely increases the cost of the loan. Unfortunately, there’s nothing you can do about it AFTER you take out the loan.
Dave,
Yes, that’s after the car loan.
May 1st, 2008 at 11:45 am
I would open two accounts (if he hasn’t already), a regular savings acount and a land savings account. The regular one should be a high yield savings account or money market fund, but the other could actually be a bond fund or balanced fund (bond + stock index funds) if it will take him more than 5-10 years to save enough to buy the land.
I would pick a reasonable amount – maybe $250 – and put that in the land account each and every month.
I would then shovel all other available funds and found money into the general savings account until it has at least $10,000 in it (or appx 3 months of expenses, whichever is larger). Once the account swells beyond that to $15,000 or so, he can start paying off the 401k in large chunks.
Leave the student loans alone; pay the minimums forever. Inflation alone might be more than 3.5% over the next decade or so!
May 1st, 2008 at 1:31 pm
Thanks!
To answer some questions…I have alot in the 401k…started putting money in it when they gave me access (over 13 years ago) but I viewed it more as a savings account than “retirement” which led to me borrowing from it because I did NOT have an emergency fund. While working on paying off my car(car will have been paid off in less than one year from the day I bought it) and 2 credit cards (cc are ZERO – yeah!), I have also been building my emergency fund. I now have 1 month put back. I will continue to grow it.
Appreciate everyone’s advice.
May 1st, 2008 at 3:58 pm
The key with the 401(k) loan is that you didn’t halt current contributions when you took it out. The double taxation issue isn’t as big a deal as led to believe.
If you borrowed $5k from your 401(k) today and paid it back using the same $5k the next day, you haven’t been double taxed on your money.
It is the interest you are paying to yourself that is double taxed. You are using after tax money to pay it and you will be taxed on that same money again when you pull it out.
You also have to consider that if you have a high allocation for stocks, you might be getting a better return from your own interest rate (especially over the last 6-8 months).
But in reality if were me, I’d “feel” better if I paid off my 401(k)money first.
May 1st, 2008 at 6:15 pm
again, you might not have a choice on which one you should pay off first, since the 401k loan is probably only a 5 year loan vice the longer term student loan. and again, you are in reality paying much more on the 401k loan than you are on your student loan. it’s good you have 1 month saved up. hopefully, you can continue to add to it, but you really need to know what the term of the 401k loan is and work backwards from there. the last thing you want is not being able to pay off the 401k loan on time. this should have been figured into the decision to pay off the cc and car loan first ahead of the 401k loan. hopefully, you aren’t in a situation where your extra disposable income won’t be sufficient to pay off the 401k loan within the loan’s term.
May 2nd, 2008 at 9:46 am
Definitely pay off the 401k loan first.
Student loan interest is also tax deductible even if you don’t itemize; so not only are you paying a higher rate on the 401k loan, the cost of the student loan is actually less than the interest rate.
May 15th, 2008 at 9:44 pm
I would just like to add that with a 401k loan that size you might want to reconsider how you have your remaining balance distributed. In my plan it would be like you had an extra 24,000 in a bond fund. It would throw off your investment mix. You could minamize some of your investment loss that way. I agree with “Your Thoughts”. Earmark the money, because niether of the loans seems to have that bad of terms.
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