Dear Dr. Don,
With the terrible rate of return I am currently experiencing with my 401(k), I am wondering if I should be taking loans from the 401(k) to pay off other loans.

As I see it, if my 401(k) loan is at 4.25 percent and my auto loan is at 5 percent, I am experiencing a 9.25 percent return on my 401(k) money. I have not seen a fund in my 401(k) plan making this type of return in 2010. Am I missing something?
— Rich Repayments

Dear Rich,
Your question got me to revisit a Federal Reserve Board working paper by Geng Li and Paul A. Smith, “New Evidence on 401(k) Borrowing and Household Balance Sheets,” referenced by David Wessel in his May 29, 2009, Wall Street Journal article, “Rethinking Conventional Wisdom About 401(k) Loans.”

In the paper, the authors propose a checklist as to whether a 401(k) loan might be advantageous to an employee, reprised below:

  1. If you did not borrow from your 401(k), would you borrow that money from some other source (e.g., credit card, auto loan, bank loan, home-equity loan, etc.)?
  2. Would the after-tax interest rate on the alternative (non-401(k) loan exceed the rate of return you can reasonably expect on your 401(k) account over the loan period?
  3. Would you be able to make your 401(k) loan payments without reducing your regular 401(k) contributions?
  4. Are you comfortable with the requirement to repay any outstanding loan balance within 90 days of separating from your employer, or pay income tax and a 10 percent penalty on the outstanding loan?

If the participant can answer “yes” to all four questions, the 401(k) loan could be advantageous to them; otherwise, other options might be better.

Conventional wisdom discourages 401(k) loans because the loan repayments are made with after-tax dollars. The loan principal payments are taxed before they enter the 401(k) account, and again when they are distributed out of the account.

According to Li and Smith, that is relevant when using a 401(k) loan to replace a loan where the interest expense generates a tax deduction, such as a mortgage or home equity loan. However, it’s not relevant when the 401(k) loan replaces a credit card or auto loan, because those loan payments are also made with after-tax dollars.

The interest payments on the 401(k) loan are also subject to the double taxation, but the borrower spreads the tax cost of the interest expense over the life of the loan, thus lessening the impact by an amount approximating the interest rate on the loan.

I can’t quite get to the place where you’re effectively earning 9.25 percent by paying off a 5 percent car loan with a 4.25 percent 401(k) loan because you’re not considering what the money would have earned had it stayed invested in the 401(k) account. This year’s performance isn’t relevant; it’s what you would earn over the loan term.

The other caveat is that the spread between your car loan and the 401(k) loan is pretty tight. If you’re paying a variable rate on the 401(k) loan — say, the prime rate plus 1 percent — that spread could tighten if the Federal Reserve ever decides to start raising its targeted federal funds rate, since the prime rate is typically 3 percent over the federal funds rate.

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