Before closing on my second house, I would balk at even the idea of a 401k loan. That money is earmarked for retirement and is supposed to be growing tax free. The loan is almost always a slippery slope that leads to less savings, especially since it’s mentally easier to take a second loan after the first. The momentum from compounding/investing is lost when the money is taken out of the account. There were small fees for my administrator. I didn’t mind paying myself interest, but still. Additionally, if I wanted to quit or was laid off from my job, I would have to repay the loan in full. With great trepidation, I decided to take out the loan anyway so that I could purchase my house.
When I bought my second house in February 2016, I was scraping money together to make it through closing. This included my entire proceeds from the sale of my first house, a generous gift from both my mother and my father for my birthday, just about every penny in my checking account, and a 401k loan. I had to put 30% down in order to qualify for financing due to debt to income ratios. Even though it was a well thought out and heavily considered decision that led to essentially living for free, it wasn’t necessarily meant to be the smartest financial move; buying a house is a lifestyle choice. (Although it was a perfectly livable foreclosure purchased at ~77% of market value, so it was not a bad financial move. I would never have gone to so much trouble had it not been. The day I closed, my net worth increased dramatically.)
After taking the loan, my paychecks were automatically reduced by the payment amount each pay period. The term was 5 years, and I was paying myself back with a paltry 4%. I did not suspend the contributions, even though it was tempting. (Some plans force you to suspend contributions until the loan is paid off.) I originally wanted to pay it off ASAP. I looked into making a partial payment, and they said for partial repayments I would have to give a check to someone in my firm to mail and then would have to wait two weeks for it to show, and there was not a convenient way to do it. Long story short, I didn’t. It fell on the back burner instead. (Hint to my bank: make repayment of 401k loans easier!)
I bought a new truck in December 2016, which I chose to finance after putting a hefty payment down. I could have bought a small used car outright, but I had different needs and priorities. This auto loan, my house loan, and my 401k loan were my only debts. After a solid AirBnB season throughout the first quarter of 2017, I had enough to pay off the loan in full or pay off half my car loan. My goal was to knock out both within two years while still saving for retirement, and I hadn’t been expecting my house bookings would be so busy. It left me flush with extra cash, which meant a lot of great options.
First, I maxed out my Roth IRA for 2016. I hadn’t done that yet since it was a struggle to get the house established and the AirBnB running. Then all of a sudden, it was tax time! My deadline was weeks away. It was very important to me to tuck that money into my Roth IRA. Remember, windfalls are meant to help buy financial independence! Don’t let lifestyle inflation creep up on you, especially not due to a windfall.
Then I made my option tree for the rest of the money. I was willing to use the remaining AirBnB proceeds, my entire tax refund, and also tap into my emergency fund since I had bookings well into July already. I totaled all this up. Then I listed all the viable options in excel and started noting the reasons for and against each. I gave myself a week deadline to ensure I didn’t fall victim to analysis paralysis, came up with more reasons for and against each throughout the week and really mulled it over with no pressure, and made my choice at the end of the week.
Option 1 – Pay off the 401k loan. Would also require essentially draining the emergency fund.
Reasons For:
- Not easy to make extra payments. A now-or-never scenario since it’s easy to pay in full through website. Never underestimate the power of convenience in helping you reach your financial goals.
- Good feelings of one loan down, one to go. The snowball effect!
- Not a major risk to draining emergency fund right now. I can leave part in cash within my 401k to begin with, and invest it once I build up cash reserves. I could take another loan if truly needed (here is the slippery slope – it’s easier a second time), but the emergency fund should be built back by July.
- Can still invest the pay off in stocks.
- Extra money in every paycheck freed up. Could direct to 401k as contribution, still investing the same amount per paycheck. Could also direct to the car loan…
- Increase of net worth in my books – I don’t consider the truck an asset, and don’t include it as part of my net worth calculations.
- If I lost my job, the money would need to be paid back shortly per IRS guidelines. Paying off increases household security in the event of a job loss.
Against:
- Can always pay off in 2018… But will I???? Probably not… The last year has shown us this. I unfortunately can’t change the payment amounts, which I would have raised immediately once my cash flow went up.
- The interest rate is only 4% and I am paying myself. The car loan is slightly higher and going to a bank. Opportunity cost of it not being invested vs. cost of interest paid to bank.
- Loan repayment doesn’t count toward the annual contribution limit of 18k. If I save this money for use toward living expenses and direct more of my paycheck to 401k contributions, I could potentially save more overall by maxing out this year and repaying the loan next year while maxing that out too.
- Can’t leave my job without paying it off, but also don’t want to leave my job right now. Net neutral.
Option 2 – Pay off half of the car loan (or a portion).
Reasons For:
- Interest rate is 4.5% and paying bank. I’m not opposed to debt when the rate is low and that money can be better invested elsewhere, but it is still debt. I’d like to wipe it out, although not at the expense of my other goals.
- Could refinance. A lower payment, potentially lower rate, or lower term for the loan. The difference between my lower monthly payment could be directed back to car loan or into 401k.
- Would be an awesome jump start to paying it off. Could be enough motivation to knock it out by the end of 2017 with extra AirBnB income.
- If I pay off half and don’t refinance, it cuts off approx. 35 months and leaves approx. 38 of the 72 months to go. That’s still three years at minimum payments, though.
Against:
- Can’t get that money out if I need it for some reason.
- My emergency fund becomes my Roth IRA now… I could do a partial repayment, leave my emergency fund, and make larger payments later.
- Already have a fire to pay it off and have been making extra principal payments when I make my monthly payment.
- Also easy to make extra payments whenever I want for whatever amount I want.
- Can still knock it out by end of 2018 even with current terms.
- No increase of net worth in my book. Cars are not assets, they are tools.
Option 3: Roth IRA (partial or full 2017 contribution).
Reasons For:
- A goal for the year.
Against:
- Can always make the contribution in early 2018 or throughout rest of year.
- Easy to make contributions $250 at a time.
Option 4: Save the money in the emergency fund/savings and withdraw as needed for daily life, directing much more into my 401k.
Reasons For:
- Potentially max out my 401k for the year (one of my goals) by upping my contributions and using the money instead. Then it will be invested in a tax advantaged account.
Against:
- Would the money still be used as carefully? Would I use this as an excuse to spend more, since there’s more money there? Those plane tickets are looking really nice…
- Can still amp this up regardless once I have one less payment.
- Still paying the loans…
- The money in the account would not really be working for me… pittance for interest.
Option 5: Save money for down payment on a rental house.
Reasons For:
- Fits into my life goals.
Against:
- I’m not quite ready to start buying rental houses yet.
- The money doesn’t work for me just sitting in the bank.
- Could take a 401k loan for a rental house down the road if I find something before I have cash built up. Here comes the “It’s easier the second time” again.
Final Decision
I rejected options 4 and 5 early on because I didn’t feel like the money would be working for me in the short term. I rejected option 3 because I have until April 2018 to complete this goal, and it’s an easier one to achieve later. I decided to focus on option 1 and option 2. My goal was to knock out both my 401k loan and my auto loan by the end of the following year, and both options would give me a great start.
I decided to pay off my 401k loan in full (a real shocker based on the title, I’m sure!) and actually ended up directing the extra money back into my 401k loan as a contribution. It’s now at $750 per paycheck going pre-tax, and I am aiming to max it out for the 2018 calendar year. This is a very important step toward my financial independence. I also raised the amount each paycheck going into my emergency fund to rebuild that quickly and brought it back down again once the fund was replenished.
Fortunately or unfortunately, it’s very clear that my decision was based on convenience. I alone am my biggest hindrance in reaching my goals. Therefore, in this situation, my priority is making things easy on myself within the context of achieving my goals. I felt that I would better be able to focus on knocking out the auto loan regardless of whether or not I had my 401k payments (I’m making the auto payments anyway!), and I already was motivated to knock it out. I was definitely not motivated to work as hard on the 401k loan because they made repayment quite a hassle, and it had to be repaid in full if I didn’t want to jump through hoops.
Any one of these decisions, or a combination thereof, would have been good for various reasons. There isn’t a “right” or “wrong” decision as long as each is bringing you toward your long-term goals. However, it’s extremely important to go in with both eyes wide open. You have to think through both the benefits and the opportunity costs. Figure out your long-term goals, and then figure out how to best get yourself there.