401k Loan vs. Second Mortgage

by Gary Foreman


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I am a recent grad from business school and I have just started a new job as a loan officer. I am curious if it makes sense to repay a 401k loan with a second mortgage loan? The interest rate on the 401k loan is 8%, the second mortgage 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. It's only natural. It's a major part of any loan. Often, you can just compare the rates and the lower one wins.

However, 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. If 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

Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money and he's a regular contributor to CreditCards.com. You can follow Gary on Twitter or visit Gary Foreman on Google+. Gary is also available for audio, video or print interviews. For more info see his media page.

Take the Next Step

  • Check the big issues: interest rate, fixed or variable, secured or unsecured, and term of the loan.
  • Take your time. Read the loan agreement. Compare them side by side.
  • Learn more about interest rates, mortgages, and 401k plans in The Dollar Stretcher E-zine.

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