Finding Funds: Second Mortgage or 401(k)

Your 401(k) is a tremendous investment tool. And while many people would never touch their nest egg until it comes time for a comfy retirement, you are permitted to borrow from the fund in the form of a short-term loan. While this choice does exist as an option, there are many reasons why you should chose a flexible second mortgage instead.

Looking at your best interest

If you're weighing the options of a 401(k) versus a second mortgage loan, it's important to do a little math. Let's say you were taking out a second mortgage for $10,000 and leaving your retirement account alone. First, calculate the interest rate you'd pay to the lender minus the tax savings you would realize from deductions. For this example, assume you're in the 25 percent tax bracket, and you're borrowing at an interest rate of 8 percent. To determine the after-tax cost of this loan, use the following formula: 8*(1-.25), (8 is the interest rate, and .25 is your tax bracket). The result? You'd pay a net of 6 percent on the money you borrow-or $600.

Now, look at your 401(k) account. Let's assume it returns a growth rate of 9 percent, which is the average annual long-term return of the S&P 500. On $10,000, that would equal $900. If you were to borrow $10,000 from your 401(k) instead of choosing a second mortgage, the money wouldn't have the opportunity to grow. In effect, it would "cost" you that $900, which is $300 more than the cost of the second mortgage.

The actual interest would be calculated differently, based on the specific investment or second mortgage you choose, but the underlying concept holds true.

The above calculation does not take into account eventual taxes on the 401(k) plan, but it's too difficult to calculate the future rate when you retire, unless your crystal ball is very clear.

Hidden costs of 401(k) loans

If you borrow from your 401(k), you have five years to pay back the loan, and your plan administrator is required to charge you interest-none of which is tax-deductible. Also, if you borrow against your 401(k) and subsequently lose your job, you will need to repay the loan within one to two months. No such penalty exists, of course, for a second mortgage.

The bottom line is that borrowing against your 401(k) will likely cost you more in the long-run. When it comes to solving a monetary problem, consider the net interest rate difference, as well as the cost of borrowing from your 401(k). You'll see that a second mortgage loan should be your first option.