Should I take a loan from my 401(k) to purchase a car if I believe the amount I will pay in interest on the 401(k) loan will be less than from somewhere else?
After having paid 100 percent of my chapter 13 bankruptcy and getting it discharged, I need a new car. Is borrowing from my 401(k) for this purchase a good idea? I have the balance to borrow around $28,000 from my 401(k) at 6.5 interest interest back to myself. I believe a post-bankruptcy car loan or lease would be around 10-14 percent interest. I want to stay under a $450 for my monthly payment so I would only actually borrow around $23,000 for the car, and pay tax, title, and license fees in cash from my savings account. My income is around $125,000 per year. I am saving to purchase a house in a couple of years. Are there any serious drawbacks to borrowing from myself to keep from paying someone else 14 percent interest? I feel like the growth on the $23,000 would be less than 14 percent.
I am not fond of 401(k) loans for several reasons. First, there is significant risk because if you should leave your employer, for any reason, any unpaid balance would need to be repaid before your next income tax return is due, perhaps with 10% penalty if you are under age 59.5. Secondly, the interest would be paid with after-tax dollars which would be subject to repeat taxation when ultimately withdrawn from this pre-tax account (or any future rollover IRA). Double taxation is never good and you need to consider this as a real cost of this loan. Third, you loose out on the tax-deferred growth of the funds you borrow for the time they are not invested. Even if you believe that growth would be less than the interest rate of alternatives, your comparison is for the current year(s), but your loss is actually for the compound growth on these dollars for many years to come. You need to remember the original objective for the 401(k): to save for retirement. I encourage you to stay the course on that one goal, not do anything to hinder its progress, and deal with other financial issues separately. If you think you have other needs now, consider the improtance of having food to eat when you are 80.
Some general suggestions: try to delay this purchase until you are able to make a greater down payment; buy a less expensive vehicle even if it only lasts a couple years, you need some time to recover from the bankruptcy; explore credit unions, they usually have favorable credit terms if you join by opening a small account. No matter what your ultimate choice is, I suggest you also make extra payments on this loan to pay it off in less than the scheduled time because, while the higher interest rates are understandable at this time, they will not be appropriate for you a couple years from now, although you will still be bound by them in this loan. You do not want to extend your "punishment" any longer than necessary with high punitive rates. Also, paying it off early will effectively lower the overall cost of this loan in its entirety.
I hope this is helpful and I wish you well.
I beleive the 401k has a 5 year payback term, and the payment will typically get withheld from your paycheck. so I think it makes a lot of sense to use this account for the car financing. The hard part is going to be buying the least expensive car you can bear to drive until you are out of the chapter 13 and in your new home. If you want to sepak about this in more detail. please feel free to reach out to me.
-Jordan Jones, RFC