It’s finally time to get a new car. The supply shortages have eased and there is inventory.
But, a few things have changed…
Prices are much higher, and interest rates have skyrocketed. The average new car sells for over $45K and interest rates are in the 8-10% range. Even used cars are far more expensive.
If you have a 401(k) plan, you may be able to take a loan from your plan to finance the new car. Most 401(k) plans allow for participant loans. Some rules and rates are set by your individual plan, but regulations say a plan loan cannot exceed 5 years or $50,000. You also must make level payments at least quarterly.
There are some alluring advantages to using a plan loan to finance a vehicle purchase. Interest rates are often lower than bank sourced auto loans. You are paying interest to yourself, in a period where your portfolio may not be growing much due to market and economic conditions. It doesn’t affect your credit score, and there is no lean on the vehicle title. What’s not to like?
The plan loan comes with a big risk. If your employment terminates for any reason, the entire loan balance becomes due. Depending on the plan, it’s usually immediately or at months end. It does not matter, why your employment terminated. Whether you quit, got fired, or laid off, it’s all the same – the balance is due.
If you do not repay the loan, it will be considered a plan distribution. That means it becomes taxable income, subject to ordinary income tax and a 10% penalty if you are under age 59 1/2. Depending on your financial situation, that can range from an annoyance to a nightmare. It carries risk under good economic times, and can influence a decision on whether to switch jobs. Now that the economy faces some risk of a recession, a layoff is not when you want a large bill, either loan repayment or tax.
Everyone has their own financial situation and plan. Depending on yours, you may be better off resisting the temptation of a plan loan.
The Bottom Line: Evaluate all the risks of a 401(k) plan loan.
–Michael Ross, CFP®