12 Dec Using 401(k) loan to buy a car

Q. I’m thinking of taking a 401(k) loan when I buy a new car later in the year. It seems to make more sense to pay interest to myself than to a car loan company. And then I will have more in my 401(k). What do you think?
— Unsure

A. While paying interest on a loan to a third party is unattractive, your other options is actually worse.

Borrowing from your 401(k) should only be used as a last resort option.

The main reason you should not take out a 401(k) loan is that you will lose part of the growth that could’ve been earned had the money stayed in your 401(k), said Jim McCarthy, a certified financial planner with Directional Wealth Management in Rockaway.

For example, if the loan interest is 4 percent and your 401(k) rate of return is 7 percent, you will miss out on a 3 percent rate of return, McCarthy said.

This may not seem like much money but the 3 percent lost on $20,000 for five years is $3,185.

Also, there 401(k) loan rules which include paying back the loan with interest within five years, McCarthy said.

“If you don’t pay the loan within that time frame, then the unpaid loan amount will be considered a distribution and you will owe income taxes and potentially a 10 percent early withdrawal penalty — if you are under 59 1/2 years old,” he said. “The same is true if get terminated from your job. In this case, the loan must be repaid within nine months.”

McCarthy said if your credit is good, you should be able to negotiate a low interest rate with the car dealer.

You also don’t have to go with the loan offered by the car dealer, but you can shop around anywhere for a loan with competitive rates and terms.

Other options worth considering are taking out a home equity line of credit, borrowing from family members, or even borrowing from the cash value in your life insurance, McCarthy said.

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This post was first published in December 2016.