Using a 401(k) loan to pay for a car?

Factual Questions
1

My wife is getting ready to buy a new car, and as part of the process, is investigating financing options with credit unions, banks, and ultimately with the car company (Toyota) itself. Today she asked me an interesting question: Her 401(k) allows her to take a loan out where she pays it back through paycheck deductions (with interest) to herself, so why can’t she use that for a car loan?

To this I said, “that’s an interesting idea, but there must be some catch to it, or everyone in America would be doing this”. Hence, why I am posting it here. I am aware she could effectively have the whole loan called in if she quit (or was fired) before the loan was paid back, but that is of minimal risk because her job is very stable. We also have the money to cover the loan in an emergency fund if that ever happened, so that is of minimal risk. So I ask the teeming millions, what don’t I know and why won’t this scheme work? Or will it?

2

I have never done that, but there are lots of people at my job who have. I’ve heard no regrets.

3

I’ve used it in the past to pay off credit card debt. It depends on the interest rate you are giving yourself compared to the interest rate of a traditional car loan.

4

The potential loss of return on the investment is a major downside…over the last 5 years, say, the S&P 500 has returned ~11.2% annually overall.

5

It’s not necessarily a terrible idea. The interest rate of the 401k loan is likely more than you could get from the bank, but you’re paying the interest to yourself. You might look at as a way to put a little bit extra in your 401k. However, it’s likely that many investments would grow by more than whatever interest you’re paying. So if your 401k investments are growing at 10% and you take a loan where you pay back at 6%, you’re actually losing 4%.

If you have good, stable jobs, you can likely get a very good rate on a standard car loan. It’s likely overall better financially to get a regular loan rather than take money from your 401k and lose any gains that money might have achieved.

6

** I found this information:**

401(k) Loans

Not all 401(k) plans offer loans. When your employer launched your company’s plan, he decided whether or not to permit loans. You can only borrow money from your 401(k) if it allows loans. If you can borrow from your 401(k), the IRS limits the amount you can borrow. You may borrow 50 percent of your vested amount up to a maximum of $50,000. If you have $100,000 or more in your account, you borrow up to $50,000. If you have $80,000 in your 401(k), you can only borrow up to $40,000.

Repayment

You need to repay your 401(k) car loan within five years. If you don’t, it will count as a withdrawal and the IRS will charge you taxes and penalties. You also need to pay interest on top of the loan balance. Your loan repayment schedule depends on your employer. The IRS requires you to make loan payments at least quarterly, but your plan may demand more frequent monthly payments. Some companies let you use an automatic payroll deduction to make your loan payments. This makes sure you never miss a payment and default on your loan.

401(k) Loan Advantages

A 401(k) car loan has several advantages over other types of debt. You don’t need to pass a credit check to borrow from your 401(k), so you are guaranteed to get the money. A 401(k) loan also generally charges a lower interest rate than a regular car loan. Lastly, you are paying your loan back to yourself. Both the interest and principal payments go back into your 401(k), so you’ll have access to this money in the future. You’re financing the car purchase yourself and not relying on a creditor, so you get the interest rather than a bank or your 401(k) plan administrator.

401(k) Loan Disadvantages

The biggest problem with a 401(k) loan is the cost of not paying your loan on time. If you don’t pay your loan back, the IRS counts the loan as a withdrawal. You’ll owe income tax on the entire loan amount, and if you are younger than 59 1/2, you’ll owe another 10 percent penalty on the loan. If you quit or lose your job for any reason, you’ll need to pay back your loan in full within 60 days. If you don’t, the IRS considers the loan in default and imposes the corresponding taxes and penalties,

A 401(k) loan may also come with opportunity costs. If the financial markets increase significantly, you lose the ability to make gains on the money you took out as a loan.

7

The catch is that you are gambling on your rate of return. Let’s say that your 401k pays an 8% rate of return. Let’s pretend that your car loan is for 6%. You’re actually leaving money on the table by taking it out of your 401k. What you’re doing is saving on the interest rate by paying it to yourself, but you’re losing out on other people paying you to have your money. When interest rates are very high, then borrowing from your 401k can make sense (although missing out on those interest gains could push off your retirement or lead to you having less money in retirement.) The interest that you’re putting in is also double-taxed, so that has to factor into your calculation. (It’s taxed once when you take it out of your paycheck to pay the loan and then taxed again when it is dispersed to you in retirement.) I won’t say that it never makes sense to do a 401k loan, but it’s more complicated than simply ‘free money.’ Of course, if your 401k tanks, then it’s actually incredibly awesome to have had a 401k loan since the loan won’t take those losses and accumulate at a decent rate of return.

8

I think if she has to consider withdrawing money from her 401(k) to finance the car, she should search for a less expensive car that doesn’t require that step.

Disadvantages are that she’ll forego investment growth while the loan is outstanding and any late payments are taxable and subject to penalties.
If she she quits, gets fired, or gets laid off, she could (and likely is) required to pay the loan back in full immediately. If she doesn’t, the loan with be considered a taxable early withdrawal and she will have to pay both income taxes and penalties on the loan balance.

She will “get interest” only from herself. If she wants to pay interest to herself, she should save money, whether in her 401(k) or in taxable accounts. If she saves money in taxable accounts, she can use it however she wants, whenever she wants, with no tax penalties.

I recommend buying a cheaper car and paying it off as soon as she can. Shop around carefully for the car and the car loan. Don’t be rushed into spending too much or making a bad decision. Good luck.

9

Good post, Jasmine.

The big issue with taking money out of your 401k is that the larger the pot of money you have in there, the faster it will grow, kind of like a snow ball rolling down hill. Taking money out reduces the size of that pot. You are required to leave enough money in the 401k to cover the loan should you lose your job tomorrow. So there goes the money that you thought you were going to put back in.

Even a stable job can disappear with little notice. So say you have 60k in there and you take out 20k. Bam, you lose your job or something else happens. The loan becomes due immediately, whatever you haven’t paid back will come out of the remaining money. The amount will be need to be reported as income for that year and subject to 10% penalty. And the amount will be added onto your income for that year, possibly moving you into a tax bracket that your withholding for that year has not prepared you for. So additional taxes.

It can be a good idea if you do not qualify for another type of loan with a reasonable rate. If you can get a reasonable loan any other way, leave that money alone. You want growth and the bigger the pot the faster the growth, usually. And it takes time to recover. 40 year old you might not care, 60 year old you will wish you had found another way.

10

This is it. The one exception is if you happen to borrow from your 401K immediately before a major recession (see “timing the market”). Then as you repaid the loan you’d be buying your shares back at depressed prices. There’s a chance you’d come out ahead on that, depending on how quickly you repaid the loan and how quickly the market recovered. But borrowing from your 401K at any other time is the same as selling off some other non-retirement investment: you lose those returns over the duration that you’re out of the market.

The rules insist that you pay your 401K back with interest so as ensure that your money will be there when you retire. This doesn’t mean it’s a good deal. For one thing, the interest in this case isn’t coming from some outside source, it’s coming straight out of your paycheck; this is not at all the same as buying bonds and having interest being paid into your account by somebody else.

If raising funds to buy a car means a choice is between:

-selling $X of an investment that earns 7-10% per year, and then buying it back over a period of 5 years

OR

-holding $X of an investment that earns 7-10% per year, and taking out an auto loan at 2-4% which gets paid back over a period of 5 years

the second option is likely to give you higher net worth at the end of five years.

My wife and I have plenty of retirement and non-retirement investments, but we still take out loans when we buy cars.

11

There is a reason that not all 401k programs allow loans. They are bad financial planning and usually have a negative impact on a retirement portfolio.

Looking back at my own 35 year retirement savings history, there has never been a five year period where I would have benefitted from a 401k loan.

12

Many car dealerships are offering 0% APR on certain models. I don’t think the 401k interest can beat that.

Still, a 401k loan is a much, much better idea that simply withdrawing money from the 401k. I have seen the aftermath of that and it is not pretty (12.5% of that is gone if you’re in California, plus taxes).

13

I’d just mention one feature of taking a 401k loan that even financial advisers/media who should know better say is a disadvantage but is not actually. See for example this link from CNN money:

It gives 4 reasons not to, three of which have been mentioned and which are correct:

  1. if you can’t pay it back on schedule it counts as a withdrawal and incurs tax penalties
  2. it will either force you to keep your job when you might want to change it, or screw you if you get laid off, until it’s paid back
  3. there is an opportunity cost to the extent the expected return on your 401k account is higher than the rate you’d get on an outside loan
  4. it says there’s a built in tax disadvantage because you pay back the 401k loan with after tax dollars, into what’s otherwise a tax deferred account on which you eventually pay tax on all withdrawals. But that point is not correct, because comparing apples to apples the alternative would be an outside loan you’d also have to pay back with after tax dollars.

3a would be that some plans don’t allow you to make new contributions into the 401k account until you pay back the loan. In that case the opportunity cost is not just on the initial amount.

But the opportunity cost as others mentioned is on an expected basis, assuming the 401k is heavily in stocks. The expected return of the stock market is higher than a typical car loan rate. However the realized return of the stock market can be lower than a car loan rate, or negative, in any given period of several years.

In general behaviorally I personally think borrowing from 401k’s is more likely to put people into the wrong mentality about what that account is supposed to be for. And many I think would just spend the contribution amounts under 3a if not allowed to put them in the account, and pay back the loan no faster than they would an outside loan. A lot of stuff in personal finance is like this, ‘on one hand on other hand’ if you assume complete rationality, but in practice one option reinforces most people’s tendency not to save enough and the other doesn’t as much. Outside load is more prudent IMO. Finding a way to get by with cars you can pay cash for is better still, again just IMO.

14

I was at a Nissan dealership last Friday and they explained to me that they could offer a $2,500 rebate OR 0% APR financing, but not both. If you take the 0% APR, you give up the rebate. So, it’s not true that they are willing to loan you money for free. On the contrary, they are offering to charge you a flat fee of $2,500 for loaning you money, rather than take a percentage of the money you borrow.

He showed me the numbers and the monthly payment came out to almost exactly the same. Take the rebate, get 6% financing, pay $347 per month. Don’t take the rebate, get 0% financing, pay $348 per month.

It’s a gimmick. They aren’t really loaning money for free.

15

Let’s address this bit, the part about paying interest to yourself. That’s not the benefit that some might think. If the growth rate of your 401k is the same as the loan interest rate, then you come out exactly the same whether you get a bank loan or 401k loan. The lack of appreciation of the money you’ve withdrawn from your 401k exactly offsets the interest you would have paid to the bank.

You should consider whether the bank rate is higher than what you think your 401k will do, but also consider that you should just leave that 401k alone until you retire.

16

I have a friend who took out this loan for a house down payment. He didn’t seem to have any problems getting it approved or anything, but he did mention it can get tricky if he ever loses his job. (Apparently there’s some provision that if you stop contributing to the 401k they can demand the loan repayment on an accelerated schedule?)

I’ve never done it myself.

17

Under that deal, no, but there are genuine 0% incentives out there - our last car would have cost the same whether we paid cash or took the 0% loan (it made no difference to the dealer - financing deal was offered by the manufacturer) so obviously we took the latter.

18

This was the case when I looked. The only catch I see is that you have to take a 60 month @ 0%, they charge interest on 72 month.

19

Not the best idea for reasons stated above, however -

I did it when overseas to buy a car from a GI who was being transferred. It was the quickest (relatively) way to get sure cash. The local Italian bank and sister American bank were not receptive. I did it on-line and had the money in my account in three days.

I also paid it back ASAP.

Go with a credit union auto loan, a CU personal loan (I get 1.99% on a 1-year $10,000 loan that I can just rollover) or a home equity /line of credit if you have that available.

20

I once used a 401k loan for a car purchase.

It was 2010. The car was old (1993 Acura NSX), so banks would not offer a car loan (maybe I’m wrong here). I could not involve my wife’s money to purchase a car that she had no interest in, so a home equity loan was not an option. I had cash for most of the cost of the car, but borrowed $10,000 from my 401k for the remainder. The plan was to own the car for a year, then sell it and pay off the 401k loan. NSX values had been steady for 10 years, so I expected minimal depreciation over 1 year.
I liked driving the car, and NSX values kept rising, so I hung onto it. Six years and 5000 miles later, I sold the car for $10,000 more than I’d paid for it. I got lucky. But after reading the posts above, by Dopers with more financial knowledge than me, maybe I wasn’t so smart.
Was there a better way to finance the $10,000 I borrowed? Could I have done better?