Ask Money

Car loan and 401(k)

Marketplace Staff Mar 14, 2012

Question:

I will be buying a car soon.  I have the opportunity to borrow against money in my 401(k) so the interest is paid to myself.  The money I would borrow against is in a money market fund, so I am not worried about “lost” growth.  Should I borrow against the 401(k) or get a separate car loan?

Response:

Chris Farrell Mar 14, 2012 Economics Editor
Many employers typically allow participating employees to borrow up to 50 percent of their vested 401(k) balance with a limit of $50,000. The interest rate is usually the prime rate plus 1 percent.  You won’t owe any income tax or penalty on the loan amount.

That said, I’m against borrowing 401(k) money as a general rule, even when the numbers favor the loan. I don’t like the bundle of risks. 

For one thing, it’s hard enough for most of us to fully fund our retirement plans. It’s important to focus on building up savings. 

You’re borrowing from your retirement fund to buy a sharply depreciating asset — a car.

A major risk embedded with a 401(k) loan is that if you lose your job or change employers, you have 60 days to pay it off. The amount outstanding after 60 days is treated as an early withdrawal, and in that case, you would be hit income taxes and penalty (assuming you’re under 59 1/2). 

Instead of tapping into retirement savings, I would take advantage of OPM: Other People’s Money. You aren’t paying much in interest these days. There is no prepayment penalty with auto loans, so you can always accelerate your payments.

It’s good that the 401(k) loan option exists. It’s an emergency fund to your emergency funds in a real pinch. But for a car? If it were me, I’d come up with a different method of financing the purchase.

What do others think? Am I too conservative in my approach?

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