401(k) loans are still … loans

Just when we thought our non-mortgage debt was paid off, we remembered about our 401(k) loans …

I've talked a number of times about Dave Ramsey's Financial Peace University. I recommend it regardless of whether you feel you need help with your finances or not. (My wife and I learned a lot more than we thought we would!)

I credit Financial Peace University for getting us into the habit of budgeting. We have a very simple mostly-pen-and-paper method for budgeting that we've stuck with.

401(k) loans? Still at Baby Step 2

Part way into the course, we thought that we were rocking through the Baby Steps.

Here are Dave Ramsey's 7 Baby Steps to Financial Peace:

1. 1. Save $1,000 to start an emergency fund
   2. Pay off all debt using the debt snowball method
   3. Save 3 to 6 months of expenses for emergencies
   4. Invest 15% of your household income into Roth IRAs and pre-tax retirement funds
   5. Save for your childrenâ€s college fund
   6. Pay off your home early
   7. Build wealth and give

We had no credit card debt, student loan debt, or car loans. And by surrendering a universal life insurance policy after we got term life insurance through my work, we had three to six months of living expenses easily.

So … we were on Step 4!

Or so we thought, until Dave got into 401(k) loans.

What are 401(k) loans?

Dave laid it on my heart that I had to pay off our 401(k) loans (actually, Thrift Savings Plan loans for us, but basically the same as 401(k) loans) before working toward 15% investing.

401(k) loans are, in a way, “borrowing from yourself.” It's taking money out of a qualified retirement plan, and paying it back over time (usually with some cost) to avoid early withdrawal penalties.

(On the plus side, failing to pay back these loans doesn't hurt your credit. It does become a tax liability, though, because the outstanding principal is treated as an early distribution.)

At the time, we had two loans against our plan. One was a general-purpose loan that came about when we replaced our failing central air units and re-sided our house. The other was a residential loan that we used for maintenance and structural landscaping.

At the time, they totaled about $25,000.

Because I thought of these loans as “borrowing from myself,” I hadn't been in much hurry to pay them back.

Not borrowing from, but borrowing against

I should have taken cues from the language our previous life insurance company used for loans: borrowing against the policy.

I wasn't borrowing from myself; I was borrowing against my retirement plan. This creates a liability against my asset, which was my retirement plan.

These are the costs of my loans:

• A loan origination fee. This was deducted at the start of each loan.
• Interest. For our loans, this rate wasn't nearly what a credit card balance would cost, but it was still a few percent.
• Lower paychecks. The payments for these loans came right out of my paychecks: $260 every paycheck.
• Lost compounding. The borrowed money wasn't earning interest, dividends, and capital appreciation, so those earnings didn't go back into my retirement accounts.

Borrowing against my retirement plan costs.

Snowball these suckers away, too

OK, so 401(k) loans are loans, just like any other.

We can pay them down faster than the minimum just like with any other loan: the debt snowball method.

Here's how we began:

1. We got a payoff amount for the smaller loan. The two loans totaled about $25,000. The residential loan was about $20,000; the general-purpose loan was the remainder. We got a payoff amount for the general-purpose loan, and … paid it off.
2. We adjusted the amount paid against the residential loan after the first payment went away. This is the snowball part. We no longer had the paycheck deduction for the general-purpose loan, so we began throwing that at the residential loan. The take-home amount of the paycheck was roughly the same as it was when we were paying on two loans.
3. We pay off these loans faster. So that we can get to the fun stuff in the later Baby Steps. Those loans get in the way.

So … yeah, we still have some non-mortgage debt to pay off, once we finally get honest about it!

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