Clark Howard - Interesting 401(k) Loan Advice

[JohnH]

I was listening to Clark Howard tonight and he mentioned a new twist on an old question which comes up now and again - namely "Should I borrow against my 401(k)."? Most of the time, the answer is a resounding "no", but he carved out an exception that even he acknowldged was highly unusual.

He was talking specifically about people who have existing home loans and are looking to refinance in order to take advantage of today's low rates but because their FMV has dropped they can't get approval. People are seeing situations where they can get a 2% or more drop in the rate and recover their transaction costs in a year or two if they don't get tripped up by the appraisal.

Clark suggested that a 401K) loan might be used to pay down principal on the mortgage enought to get the LTV in line. I thought that was an interesting exception to the general rule in cases where the numbers otherwise work out. Naturally the borrower needs to know about the risks of losing their job with a 401(k) loan in place and all the other cavets, including no tax deduction for the interest on the 401(k) loan, but I thought he made an excellent point. There are plenty of people out there who have resigned themselves to missing the boat on the low rates when in fact this might be a clever strategy with minimal risks for many of them.

[veritas]

Disagree

Too risky.

If you lose your job, you have a tax problem. Secondly you won't be able to pay the mortgage payment even at the lower rate which is the time you may need to borrow to keep from losing the home.

Since in many cases they are trying to lower the monthly payment, how does it help them to have an additional loan?

Nearly everyone of these folks have consumer debt. The need to focus on paying that off.

Lastly the money is not going to be able to take advantage of long term earnings in the market.

[S T]

Really Risky

Veritas is correct,
What if that client took the 401K loan and borrowed and paying back interest to "themselves" No tax deduction

But what happens if they receive that "layoff notice" "Severance Pack Notice" in a few months

All of that 401K loan is due and payable, and if the client doesn't pay it back, by "separation date" a 1099R is issued for the 401K loan outstanding. And now we have taxable income and possibly subject to Code 1 - early penalty

I just received a client notice on one and we are trying to figure out how to deal with it for 2010 Fortunately this client has until 9/24/10 to make some decisions due to a severance package, so we can hopefully avoid the 1099R reporting and potential early withdrawal penalty, code 1

Sandy

[JohnH]

Probably too risky if they need a lot of money to do the deal. But what would you say if, for example, the client has a $200K mortgage at 7-1/2%, needs to get the loan balance down to $180K in order to refi at 4-3/4%, and the 401(k) loan is the only source of cash? (That's a realistic scenario, IMO) Would your answer automatically be "Don't do it?"

[Gary2]

Back when the computer industry had nowhere to go but up - in the 80s - borrowing against the 401k was considered a reasonable strategy, especially when the housing market was also taking off.

Nowadays, I make sure clients understand the risk, but I emphasize that I can't comment on their job security. At this point in time, people with confidence in their job security are probably right, while others decide that the gamble is worth it. Either way, I prefer they make an informed decision rather than having me make it for them.

[Roberts]

Too risky.

If you lose your job, you have a tax problem. Secondly you won't be able to pay the mortgage payment even at the lower rate which is the time you may need to borrow to keep from losing the home.

Since in many cases they are trying to lower the monthly payment, how does it help them to have an additional loan?

Nearly everyone of these folks have consumer debt. The need to focus on paying that off.

Lastly the money is not going to be able to take advantage of long term earnings in the market.

They should pay down their debt but you say they shouldn't take THEIR MONEY and pay down their debt? If they can borrow $20,000 from their personal 401-k (it's THEIR MONEY) and save $3,000 per year in interest, why not? They aren't likely to earn 15% per year in this market anytime soon. Your argument is that they should play arbitrage by investing long in the stock market and being highly leveraged with debt and hoping the 401-k outperforms the interest on the debt.

[veritas]

Shifting chairs

They should pay down their debt but you say they shouldn't take THEIR MONEY and pay down their debt? If they can borrow $20,000 from their personal 401-k (it's THEIR MONEY) and save $3,000 per year in interest, why not? They aren't likely to earn 15% per year in this market anytime soon. Your argument is that they should play arbitrage by investing long in the stock market and being highly leveraged with debt and hoping the 401-k outperforms the interest on the debt.

around on the Titanic.

1. If they lose their job they are screwed.

2. They probably won't reduce their monthly payments since they will have a new loan to the 401k.

3. They will lose the long term earnings on the 401k which will never be replaced.

4. Suppose they have a real emergency at some point and need to borrow or cash out from the 401k?

[JohnH]

I see there are several different viewpoints on this matter, and I'm inclined to stick with Clark when the situation is appropriate. Good discussion, BTW.

I agree it's not a cut-and-dried issue, but I should point out that there's much more to a refi than simply trying to lower the payment. The wisdom of accepting a higher payment in return for a significant rate reduction is often easy to see - people sometimes switch from a 30-year amortization to a 15-year amortization when the rate reduction makes it worthwhile and the budget will allow it.

I'm coming around to the concept that if the numbers work out and there's reasonably good job security, then the 401(k) is simply another funding source - nothing more and nothing less. It isn't sacred or untouchable. After all, financial security isn't as much about "qualified" vs "unqualified" funds as much as it is about total assets and total liabilities. Which "bucket" the assets happen to be sitting in at the moment is not the decision-making issue which trumps everything else.

[Bees Knees]

Something that has not been mentioned: The strategy assumes the homeowner cannot re-finance because the existing mortgage is higher than the fair market value of the home. That indicates the homeowner is not really in a very healthy financial situation to begin with.

As a tax preparer, I would be very cautious about giving financial advice to someone who has one foot in the street. Anything goes wrong, and you can be sued for giving advice that backfired. My advice is to stick with tax preparation, and let the financial planners suggest taking the risk.

[taxxcpa]

Mortgages

Over 20 years ago I bought some GNMA securities which were based on 9% mortgages. They were worth about $50,000 each when I bought them. Now most people re-financed or sold their home and paid off the underlying mortgages, but now the original $ 50,000 amounts are down to about $ 500 remaining principal. Yet some people have never sold or refinanced and a small percent are still paying the mortgages at 9% interest.

I've always re-financed when rates drop, except on my current mortgage which is difficult to refinance for a number of reasons. Fortunately it is not a lot higher than the going rates.

[JohnH]

Sometimes you just can't make the right call. I refinanced from a 6% rate down to 4.5% last fall, paying about $3K in transaction costs. Thought I'd done pretty well at the time. Now 5/3 bank is trying to expand their book in this area and they're offering 4.88% for a $299 fee. Not saying I made a mistake at the time, but it sure would have been nice to have waited another 6-9 months. Too bad we all don't have a crystal ball.

[veritas]

more and more

Mortgages are going to 15 years. I guess the boomers figured out the
spending spree wasn't all it was cracked up to be.

Clark Howard gives good advice on how to be a clever debtor.

[JohnH]

Along with Consumer Reports, I place him very high on the reliability scale. Probably the most unbiased voice on the air, IMO. He's saved me lots of money over the years, as well as some clients I've told about him.

[Bees Knees]

My two cents worth…

I know someone who makes $2.4 million a year. And I know someone else who makes less than $20,000 per year. Obviously, the richer one has more toys and can afford fancier vacations. But both have a roof over their heads, food on the table, and clothes on their back. Surprisingly, the one who makes less than $20,000 is debt free. The one making $2.4 million has a mortgage.

The difference is not how much money you make, but how much of your money you choose to spend. I know that as I went through life, the more money I made, the more I spent. I went from macaroni and cheese dinners to having pizza delivered regularly. The one thing I did NOT do, was buy a house I could not afford. I believe the ultimate financial goal of everyone should be to become debt free as soon as possible. Those without a mortgage are less affected by our current housing crises than those who have a mortgage. It is possible to work towards paying off your house, paying cash for a car, and paying off credit card balances each month. It may take some spending discipline, but it can be done, even in today’s materialistic world.

The key is not making more money, but living within your means. Any extra cash you come across goes towards paying off your mortgage, credit cards, car, etc., rather than going into some investment. I disagree with financial planners who think you should carry debt at a lower rate so that you can earn more in the stock market. There is no risk in not having any debt. You can have the same standard of living with no debt for half the income a typical person with debt needs to earn.

Just my two cents…

[JohnH]

Good advice. It seems that some people cannot resist the urge to get ever more heavily leveraged as their incomes rise. It's a fun ride until something goes wrong. I'm not as concerned as you are about carrrying reasonable debt on a home, provided there's plenty of LTV cushion and the mortgage doesn't drain an excessive amount of one's income. I consider a good rule of thumb to be a house payment that doesn't exceed what one would pay to rent a property they would be comfortable living in. But as you say, many people feel they must constantly trade up.

Same for cars - maybe more so. I know people whose cumulative waste of wealth on cars exceeds their housing mistakes, just because they imagine it's important to be seen driving something shiny and luxurious. They never seem to see the huge drain this places on their finances.