Last Gasp or Smart Financial Decision?
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
With the best of intentions, Dan Caplinger of The Motley Fool recently penned an article called “These Last Gasp Loans Are A Bad Move.” While I'm sure that for some, his topic of 401(k) loans are indeed a bad move, suggesting that this is universally true I think reaches too far. His primary point was that many workers are taking out 401(k) loans possibly without being aware of the potential problems they could cause. However, there are at least two specific cases that I can think of where a worker would be smart to borrow against their own assets rather than face other consequences.
Dan specifically cited offers from companies such as JPMorgan Chase (NYSE: JPM), Citigroup (NYSE: C), and Bank of America (NYSE: BAC) as potentially attractive alternative options. I'm sure all three companies would be happy to know that I personally have utilized offers from each of them exactly as Dan suggests. For instance, Chase on a regular basis sends out mailers suggesting customers sign up for credit cards usually offering a 0% interest rate on both purchases and balance transfers for 12 months. These offers normally come with a 3% to 4% balance transfer fee that is charged up front. Citigroup on the other hand, has been trying to buy credit card balances by offering 0% for as long as 21 months in certain cases, while charging a 3% to 4% fee upfront to the customer. Not one to be outdone, Bank of America has offers of 0% for around 12 months, and I've also seen some offers of 1.99% for a similar time frame. There is a slight difference in what the three companies require as a minimum payment. From experience, Chase normally expects a 2% minimum payment based on your average balance. Citi on the other hand, normally expects a 1.5% minimum payment, and Bank of America in some cases only requires a 1% minimum payment. These certainly sound like attractive options, and for consumers who have good enough credit to qualify, I usually would recommend going this route. The problem is what do consumers do who don't qualify for these offers?
There are two specific examples I can think of where a consumer who doesn't qualify for the above offers would be well served to consider a 401(k) loan. The first is in the instance of existing credit card debt that they are unable to transfer to a lower interest rate. According to recent studies, the average American consumer carries a $6,472 balance on his/her revolving credit. In addition, this average balance comes with an average interest rate of 14.93%. To pay this type of balance off using just a 2% minimum payment would take 27 years, and the consumer would pay $9,582 in interest charges. Even if the debtor paid a set $130 a month, and did not lower the minimum payment as the balance dropped, the higher interest rate would cause the consumer to take seven years to pay off this balance. Again because of the higher interest rate, even in this seven year time frame the consumer would pay nearly $4,000 in interest. Compare these numbers to a 401(k) loan, which traditionally can have a term of up to five years. With the current prime rate, the interest rate might be as low as 5% or less. Using these assumptions, the worker taking this 401(k) loan would have a minimum payment of about $122 a month and in five years would pay just $856.08 in interest. Considering this borrower would pay over $3,000 less interest, and would pay this debt off in two less years with the 401(k) loan, even the tax consequences would not offset this amount of savings.
Traditionally speaking, anyone who takes a 401(k) loan pays no taxes unless he or she defaults on the loan. While Dan mentions this, the most common instance of a 401(k) default is when the employee leaves the job that this 401(k) resides with. Even if the employee is unable to cover this loan and has to pay 20% in taxes and the 10% tax penalty, the total cost of these taxes and penalty would still be less than $2,000. Considering in the worst-case scenario, the employee would save over $3,000 in interest, even a $2,000 tax hit still means the loan makes sense. While the 10% tax penalty is certainly lost money, ordinary taxes are unavoidable on the balance. The 20% in taxes represents something that would have to be paid at some point when the funds were drawn from the 401(k). While this might be slightly higher than what the employee would have paid down the line, these taxes are not completely unavoidable. The other situation where a 401(k) loan probably makes sense, would be in the case of a problem with another debt.
If an employee is having problems meeting an ongoing debt, and is unable to make scheduled monthly payments such as a car loan, using the 401(k) to avoid an issue like repossession might make the most sense of all. While this is a more extreme case, an employee with no vehicle can't easily get to work to continue to earn income. Chances are a 401(k) loan and its lack of credit application is the best hope to avoid a negative consequence on this other debt. This certainly would make more sense than going through a payday lender who might charge interest rates that can run as high as 30% or more. As you can see, in both these scenarios, taking a 401(k) loan might be the most financially responsible choice the consumer could make.
MHenage owns shares of JPMorgan Chase & Co. The Motley Fool owns shares of Bank of America, Citigroup Inc , and JPMorgan Chase & Co. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.