Sunday, April 13, 2008

401(k) Loans

Top Line: Friday's market was not what you would call a reason to buy stocks. With GE's bomb just before the market opened, the stock market took a tailspin. Now, the question becomes what to do or what will the market do? The answer should be given to us sometime early during this week. We think the GE news is an indication of just how deep the financial pain is, not that it should surprise any of the Update readers. It's just that the surprises are to the downside and we are having a difficult time maintaining our rally trading stance. Hopefully, we can see a bounce after this big GE selloff so we can at least get short.

It's late on a Sunday evening, so we're going to just answer one quick question that we received late last week. A recent reader asked a question about borrowing some money from a 401(k) and was it a good time based on interest rates where they are now. So...we feel compelled to take a stab at this.

Here's what we think we know about the 401(k) loan, which is not a lot but more than some we suspect. Typically, you can borrow up to half of your balance with a max of about $50K the last time we checked. The normal terms are fixed payments at a fixed rate and a repayment period of five years. The payment is deducted from your payroll check.

If you no longer work at the company, you will most likely need to pay off the balance of the loan or, if you can't pay it off, take a "distribution" to pay off the loan. A distribution means the company would take money out of your account and pay off your loan--this is a taxable event with penalties.

The interesting thing about a "loan" from your 401(k) is that you are actually borrowing from your money. When you take this loan from yourself, the balance of your loan has to be in "cash" equivalents and not invested in other funds. The obvious reason is that the money is being taken out of your account and paid to you. Another way to look at this is the fund manager has to invest the cash fund and one way to do it is to loan it to you, instead of buying short term paper with it.

The bottom line is that your loan has a fixed rate of interest but the "cash" fund you're in is variable. What we mean is that you should earn interest on your balance. It's a little backwards but you get interest on the loan paid into your account. We don't know if this is really done but that's the way it's supposed to work. If you don't understand this, then please read the fine print of your loan so that you can find out just what you are getting yourself into...please.

There is the obvious rant that has to come from the Update on loans from your 401(k)...forgive us but we have to say this. We do not like the idea of taking loans from your 401(k). Yes, the rate is good and you have the money to borrow but, no, we just don't like the terms all that much...see above. So much of what we read is that people who have saved for retirement now are taking the money out to pay for living expenses. These are living expenses that were supposed to be in retirement, not at age 42. But, if you must borrow then at least know what you're getting into...

Ok, thanks for letting us say that. You wanted to know about interest rates on your loan. Well, we don't know for sure what will happen to rates but some of the great bond market fund managers suggest that Treasury bond yields are headed up. Who can blame them when rates are at incredible lows?

The short end of the curve, for loans shorter than five years for example, the rates have dropped on Treasury securities. From our standpoint, the short end of the curve will not be going up anytime soon, but the question is will the 401(k) loan interest rate go down any more?

We do not think the loan interest rate can go down very much for these loans due to the very low rates at the short end of the curve. The Fed just lowered rates to 2.25% on overnight funds and the lowest those have been is 1% this decade. So the most they can probably drop is back down to 1%, although we're not sure what the Fed might do. They could only lower them to 0% but the question is still what will happen to the 401(k) loan interest rate?

We think there is very little downside rate action on these types of loans. So, if you must borrow, this rate is near the lowest you will receive, in our humble opinion.

Reading material:
Gretchen Morgenson on HELOCs (Home Equity Line of Credit) and Rate Auction Failure Fallout

FSI: 76.95 (still holding up pretty well)

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