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Second Mortgage Versus 401K Loan

July 10, 2000

"I need $10,000 for a home improvement. I can either take out a home equity loan or I can borrow from my 401K retirement fund. Would the tax benefits on the home equity loan outweigh the advantage of borrowing my own 401K money and paying myself back?”

Not necessarily, because the 401K also has tax benefits.

The rule is that you borrow at the lowest after-tax cost. For a home equity loan, ignoring upfront costs, which usually are small, the after-tax cost is the interest rate less the tax savings. You can calculate this by multiplying the interest rate by 1 minus your tax rate.

The cost of borrowing from your 401K is not the rate you charge yourself because that goes from one pocket to another. The cost is what your loan would have earned had you kept the money in the 401K. This is sometimes called an "opportunity cost". Since your 401K accumulates tax free, the total return on the fund is a close approximation of the after-tax cost.

If your 401K has been earning more than the after-tax cost of the home equity loan, the opportunity cost of borrowing from your 401K is higher than the cost of the home equity loan.

Let’s assume you need $10,000 and that you have $100,000 in your 401K earning 10% a year. The rate on a home equity loan is 8.5% and you are in the 28% tax bracket. The after-tax cost of the home equity loan is 8.5x(1 - .28) or 6.12%. Since the 10% cost of borrowing from the 401K is higher than the 6.12% cost of the home equity loan, you should take the home equity loan.

To check on the logic, lets assume that both loans would be repaid in full after one year. We can then compare the borrower's balance sheet in the two cases at the end of the year.

If you take the home equity loan, you will have $110,000 in your 401K, you will pay the lender $10,850, and you will have a tax saving of $238. Your financial wealth will therefore be $110,000 - 10,850 +$238 = $99,388.

If you borrow from the 401K, you will have only $99,000 in your account at year-end because you don't earn a return on the $10,000 that you have drawn. Whatever you pay back to the fund does not affect your wealth. You are thus $388 poorer if you borrow from your 401K.

The caveat is that taxes must eventually be paid on the earnings on your 401K. But this doesn’t happen until you retire, and even then the tax payments will be stretched out over time unless you elect to withdraw a lump sum.

The assumption that the cost of borrowing from a 401K is the total return on the account is thus valid for most borrowers. The exception would be those approaching retirement who anticipate withdrawing a lump sum when they get there.

November 20, 2001 Postscript:

Another reason not to borrow against 401K accounts is that if you are laid off, the loan must be repaid within a month or two. Otherwise, it is considered by IRS as a taxable distribution on which income taxes, and perhaps a 10% early withdrawal penalty, are due. While failure to pay a home equity loan can result in the loss of the home, a layoff necessitates repayment of a 401K loan but not a home equity loan.

"I need $10,000 for a home improvement. I can either take out a home equity loan or I can borrow from my 401K retirement fund. Would the tax benefits on the home equity loan outweigh the advantage of borrowing my own 401K money and paying myself back?”

Not necessarily, because the 401K also has tax benefits.

The rule is that you borrow at the lowest after-tax cost. For a home equity loan, ignoring upfront costs, which usually are small, the after-tax cost is the interest rate less the tax savings. You can calculate this by multiplying the interest rate by 1 minus your tax rate.

The cost of borrowing from your 401K is not the rate you charge yourself because that goes from one pocket to another. The cost is what your loan would have earned had you kept the money in the 401K. This is sometimes called an "opportunity cost". Since your 401K accumulates tax free, the total return on the fund is a close approximation of the after-tax cost.

If your 401K has been earning more than the after-tax cost of the home equity loan, the opportunity cost of borrowing from your 401K is higher than the cost of the home equity loan.

Let’s assume you need $10,000 and that you have $100,000 in your 401K earning 10% a year. The rate on a home equity loan is 8.5% and you are in the 28% tax bracket. The after-tax cost of the home equity loan is 8.5x(1 - .28) or 6.12%. Since the 10% cost of borrowing from the 401K is higher than the 6.12% cost of the home equity loan, you should take the home equity loan.

To check on the logic, lets assume that both loans would be repaid in full after one year. We can then compare the borrower's balance sheet in the two cases at the end of the year.

If you take the home equity loan, you will have $110,000 in your 401K, you will pay the lender $10,850, and you will have a tax saving of $238. Your financial wealth will therefore be $110,000 - 10,850 +$238 = $99,388.

If you borrow from the 401K, you will have only $99,000 in your account at year-end because you don't earn a return on the $10,000 that you have drawn. Whatever you pay back to the fund does not affect your wealth. You are thus $388 poorer if you borrow from your 401K.

The caveat is that taxes must eventually be paid on the earnings on your 401K. But this doesn’t happen until you retire, and even then the tax payments will be stretched out over time unless you elect to withdraw a lump sum.

The assumption that the cost of borrowing from a 401K is the total return on the account is thus valid for most borrowers. The exception would be those approaching retirement who anticipate withdrawing a lump sum when they get there.

November 20, 2001 Postscript:

Another reason not to borrow against 401K accounts is that if you are laid off, the loan must be repaid within a month or two. Otherwise, it is considered by IRS as a taxable distribution on which income taxes, and perhaps a 10% early withdrawal penalty, are due. While failure to pay a home equity loan can result in the loss of the home, a layoff necessitates repayment of a 401K loan but not a home equity loan.