Finance / accounting brainiacs step right in

[IronWing]

For reasons of pure obsessive compulsiveness I'm trying to figure out the effective interest rate (opportunity cost) of borrowing money from a 401k. The 401k is invested in a mutual fund. I have the following info:

• Loan principal in terms of number of shares sold and price per share on date the loan principal was withdrawn from the mutual fund.
• Date, share price, number of shares bought for each loan payment.
• Present market value of the original shares so I know what my return would have been on the principal if I hadn't taken out the loan.
• Present market value of all shares purchased in repayment of loan
• The 401k loan requires the payment of "interest" at a fixed rate. Since the interest is going straight into buying shares it isn't really a cost but more of a gimmick to force the borrower to increase their savings rate to make up for taking out the loan. I have the breakdown between principal and interest for each payment if that needs to be factored in.

I understand that the opportunity cost won't be really knowable until the loan is fully paid back as share prices will keep bouncing around throughout the life of the loan. So instead I'm trying to figure out the effective interest rate on any particular date given the share price for that date.

I used the 401k loan to pay off another loan so I'd like to compare the opportunity cost of the 401k loan to the cost avoidance enjoyed by paying off the other loan. I can figure out the interest savings from paying off that loan quite readily.

Any tips on how to complete the calculation of an effective interest rate on the 401k loan?

 

[IronWing]

bump for morning crowd

 

[Sho'Nuff]

As a matter of practical advice, I would never, ever, ever borrow from your 401k, unless dire circumstances force you to do so.

But if you are intent on calculating the cost of borrowign from your 401k, the following link points to an article that dicusses the relevant considerations. There are A LOT of assumptions that have to be made

http://allfinancialmatters.com/2008/02/28/how-much-will-that-401k-loan-cost-you/

 

[IronWing]

Okay, I think I figured it out.

1. First I calculate the theoretical change in value for the original principal as if it had not been removed from the mutual fund.
2. Then, on a payment by payment basis, I calculate the change in value for each payment. I use the principal portion of each payment only, not the interest.
3. Then I sum up the value changes for the payments and subtract the that from the change in value for the original principal. This yields the opportunity cost for removing the funds from the mutual fund.
4. I then calculate an annualized rate of return.

This works for me as I almost never move money from fund to fund so the math is pretty straight forward. Also, since I continue to make contributions into the 401k at the same rate I did before the loan, there is no opportunity cost there. That is to say, my total contribution = original contribution + loan payment.

Now dealing with the opportunity cost/benefit from the interest portion of the payments is a bit more sketchy. Right now, I'm dealing with the change in value on those payments as I did the principal payments above - subtracting them from the change in value of the original principal. My rationale for doing so is that but-for-this-loan, I would not have made those contributions to the 401k.

The next item to tackle is the tax cost of the interest payments. Reading the discussion linked by soxfan, I'm leaning toward factoring in the tax cost of the interest payments. Basically the argument is that the interest payments are paid with after-tax funds and will be taxed again at withdrawal in retirement and so this first taxing should be considered a cost against the loan. Others say that these interest payments aren't really double taxed but don't really explain why not.

In case you're wondering, the current annualized opportunity cost of my 401k loan is 2.6%. The mortgage I paid off with the proceeds of the loan was at 5.125% so for today I'm a genius. However as the market bobs up and down the wisdom of the taking out the loan wanes and waxes. It kind of works like a hedge against my 401k fund or a short against it. If the market drops, my decision to take out the loan was stupendous. If the market rises, I'm an idiot again. Right now, in the early life of the loan, minor market swings have a big impact on this calculation. As more of the loan is repaid, the impact of market fluctuations should dampen.

 

[dullard]

Too much work for me to do the math for you. At least though, could you give us a rough estimate of the loan size and the costs for doing the loan. For example, if the 401K loan size was $5000, then you'd be saving 5.125%*5000 = $256/year. But, many 401K loans have a processing fee (mine is something like $75 up front and $75/year). So, if I did that, my net gain would be $256-$150 = $106 for the first year. That ends up being a pretty small gain for the effort and the risk. The risk being that the stock market behaves like normal and you lose a 10% gain on that $5000. In other words, the likely gain is $106 and the likely loss is $500. In most cases, that is a bad bet.

But, if the stock market goes sideways like it has been, you may win a bit on that bet.

 

[IronWing]

Too much work for me to do the math for you. At least though, could you give us a rough estimate of the loan size and the costs for doing the loan. For example, if the 401K loan size was $5000, then you'd be saving 5.125%*5000 = $256/year. But, many 401K loans have a processing fee (mine is something like $75 up front and $75/year). So, if I did that, my net gain would be $256-$150 = $106 for the first year. That ends up being a pretty small gain for the effort and the risk. The risk being that the stock market behaves like normal and you lose a 10% gain on that $5000. In other words, the likely gain is $106 and the likely loss is $500. In most cases, that is a bad bet.

But, if the stock market goes sideways like it has been, you may win a bit on that bet.

Yeah, basically in taking out the loan and paying off the mortgage early I take on two forms of additional risk, the first being the market risk you mention and the second is that I relieved the mortgage lender of inflation risk and rate risk. I'll probably end up paying off the 401k loan early which will leave me with plain old market risk.

The processing fee with my employer was a flat $50 upfront with no annual fee.