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Ask Dr. Don

401(k) loan refinancing

Dear Dr. Don,
In December 2000, I took out a $12,500 loan against my 401(k) account for a down payment on my house. The interest rate was fixed at Prime + 1 (10.5 percent at the time.) Prime is now at 4.75 percent, and a new loan would be at 5.75 percent.

Does is make sense to pay off the old loan and take out a new 401(k) loan for the remaining balance? In essence, I would be refinancing my current 401(k) loan at a lower rate without digging into my regular savings account. I would be digging in my regular savings temporarily to pay off the current loan, but would replenish it with the funds from the new 401(k) loan at the lower rate.
Ed Evolve

Dear Ed,
Make sure the plan's administrator will allow you to take out that second loan. Plans typically won't allow a 401(k) loan to be refinanced, but you're not technically refinancing, since you plan to pay off the loan from savings and not from the proceeds of the new loan.

Borrowing against your 401(k) is usually done as a last resort, so it surprises me that you have enough in savings to pay off the note and then plan on replenishing the savings account with the proceeds from the second loan.

Having three to six months worth of expenses in liquid investments as an emergency fund makes sense, so I can understand why you might feel the need to replenish your savings if you are using your emergency fund to pay off the loan.

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An alternate approach would be to take out a home equity line of credit to act as your emergency fund. Two years in on a mortgage, a HELOC may not be feasible. But if it is feasible, this approach keeps you from tapping your retirement portfolio to invest in low-yielding money market investments for liquidity.

You'd have the advantage of only borrowing what you need, when you need it during the draw period on the HELOC loan. Closing costs on a HELOC are much less than a new first mortgage.

The HELOC and the new 401(k) loan should start out having similar interest rates, but the interest rate on the HELOC, as a variable rate loan, will reset with changes in the index that it is priced against.

The interest expense on the HELOC may be tax deductible while the interest expense on your 401(k) loan isn't tax deductible. The 401(k) loan payments are made with after-tax dollars, and the money is taxed again when disbursed from the account.

-- Posted: June 18, 2002

Read more Dr. Don columns
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See Also
Don't forget that old 401(k)
Frequently asked questions about 401(k)s
Financial advice glossary
More Dr. Don stories

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