Good Deal

The world of money is so full of sales hope and hype that it's refreshing to have at least one, straight, no foolin', good deal. There is a bonus: this one deal brings the special delight you only get when you skin the revenooers.

So, what is it?

The only thing better than socking money away in a 401K account is borrowing it back from yourself.

Nearly everybody with the word "save" in his or her vocabulary has been exposed to some form of tax-deferred savings plan. Essentially everybody with an income has access to the plain, old individual retirement account (IRA). IBMers know these accounts as a "TDSP" (tax-deferred savings plan), while government employees are familiar with "PERA" (public employees retirement act), and university people think of "TIAA-CREF" (don't ask).

Self-employed people have access to a large array of devices involving people's names (Keogh), long strings of numbers (403 something-or-other), and half the letters of the alphabet (SEP-IRA).

The basic advantage of all these plans is the same. Their investment earnings compound at the nominal rate of return, and the IRS has to wait until retirement or withdrawal to take its cut. If your investments earn 10%, they compound at 10%. If your savings are in taxable investments and earn 10%, the IRS takes its 35% (including Colorado's income extraction), and your investments compound at 6.5%. The difference matters: a thousand bucks compounded at 6.5% for 20 years will be $3,656; at 10% it piles up to $7,328. You still owe some taxes at the end, but you're way ahead.

Most people understand the savings angle, but few have a glimmer about the advantages of borrowing your own savings. The main problem seems to be an ethical one. People who are sufficiently disciplined to save feel they are cheating if they reach into savings. If you spend your savings, it's not saving, it's anti-saving, right?

Not if you spend on the right things. If you do it right, borrowing from your savings will help you save more. Honest: no kidding. Check with your CPA. (In June, maybe, when she has time to talk to you.)

Buying a house is the best use of a 401K borrowing. For one thing, you are not "spending" the money. Making a down payment just switches an asset from cash to real estate, while blowing $5,000 on a vacation decreases net worth by the same amount.

Borrowing some savings for a down payment can make the difference between a loan with mortgage insurance and one without; or may help you make it into a house instead of a condo, or into a better house. Most mortgage loans require you to have some of your "own" money to put down: borrowed savings is acceptable for all loan types.

Borrowed savings can help in an unlikely place. Many borrowers have high monthly payments on "outside," non-mortgage debt, which often limit mortgage borrowing ability. You can approve yourself for a consolidation loan from you. Which leads to other borrowing purposes: to buy a car, for example.

Be cautious about 401K borrowing to consume. While it's true that car loan interest is no longer deductible, and a 401K loan is tax sheltered, remember that the car is going to fall in value. With any luck, and some patience, a house will gain in value.

Some hints for successful 401K borrowings, particularly for real estate transactions:

-- Check to see if you are eligible to borrow; and if so, how much, for how long, and at what rate. If you ever have a choice between a plan which allows borrowing, and one which doesn't, guess which one you should choose.

-- Start the process early. Many 401K administrators take a month or more to actually put the check in your hand.

-- Always opt for long payback periods. Monthly payments on any borrowing are more sensitive to time than to rate: $15,000 at 9.5% for four years costs $376 per month, while at ten years the payment falls to $194. Low payments are important because you'll have to qualify for your mortgage with this payment, just like any other. You can always pay the money back faster if you want (I've never heard of anyone giving themselves a prepayment penalty).

I suspect that the dedicated savers who have read the arguments above are still suspicious of this whole borrowing notion. One last pitch. When you borrow from your 401K, you are substituting your loan to you for some other 401K investment asset. Your loan to yourself is probably the best investment your 401K can make.

When you borrow from yourself, you must pay interest at a rate near prime, around 9.5% today. All investment returns should be measured against risk. Most dedicated savers are better risks than any stock, and may be safer than Treasury bonds. Risk aside, 9.5% is a better rate than you are likely to earn next year from either the stock market or the Treasury.

Pay yourself.