$tarrBuck Report for August 20, 2006: Borrowing to Save

August 20, 2006

$tarrBuck Report for August 20, 2006: Borrowing to Save

by R. M. Starr

Richard and Stacey are having one of their kinder gentler /arguments/ discussions.

Richard: Darling! Have you completely lost your mind? From now on I’m managing the money!

Stacey: But it makes perfect sense!

Richard: No it doesn’t! No more than dating for chastity or feasting for weight-loss!

Stacey: Borrowing to save does too make sense. Let me show you.

Here’s Stacey’s plan:

Take out an equity line of credit on the house. Borrow $750 a month, contribute $1250 a month by payroll deduction to Stacey’s 401(k) plan at work. Stacey’s combined state and Federal income tax rate (on each additional dollar of income) is 40% so $750 is enough to make up for the lost after-tax income.

Interest on the equity line of credit is home mortgage interest; it’s tax deductible. Investment earnings on Stacey’s 401(k) are tax-deferred. They grow fast because they’re not slowed down by taxes.

The interest rate on the equity line of credit is 8%. Stacey figures that investments in the 401(k) will yield at least 8%. The interest expense after taxes is 4.8% annually, while the investment grows at 8%. Stacey works out the figures at http://www.moneychimp.com/calculator/compound_interest_calculator.htm .

Stacey figures the accumulated debt after 20 years, assuming she writes checks on the line of credit to cover interest payments. She credits back the income tax savings. Stacey figures the value of the investment in the 401(k) after it’s grown at 8%; then she figures the after-tax value assuming the tax rate stays the same.

Here’s how it works out with just one year’s worth of contributions held for the next 20 years.

Accumulated debt (compounded over 20 years at net interest cost of 4.8% annually): $23,460.

Accumulated 401(k) wealth (compounded over 20 years at 8% annually) before tax: $73,900. After-tax: $44,340.

Bottom line on borrowing to save for a year: It costs $23,460 to earn $44,340. That’s a painless profit of over $20,000 for one year’s worth of participation and twenty years waiting.

How about doing it every year for twenty years? Accumulated debt is $302,500 and after tax 401(k) wealth is $444,600. That’s a net after tax of $142,100 with no reduction in current spending. It’s free money.

What can go wrong with Stacey’s plan?
o Investment yields may not work out.
o Interest rates on the line of credit may go up.
o Tax rates may go up.
o To sustain hundreds of thousands in debt, more than a line of credit may be needed. Richard and Stacey may need to refinance the house.

Even if everything goes according to Stacey’s plan, when is Richard right? How can borrowing to save be a bad idea?
o What if they need the money? Children’s college tuition, move to a new house, losing a job, disability. Those are all reasons why the line of credit may not be available or the money may be needed for other things. Then locking up the line of credit to support the 401(k) may look like a mistake. Still, it’s possible to borrow against the 401(k), or to take a hardship withdrawal from the 401(k) (possibly with a penalty charge).

Stacey’s bottom line: Free money is well worth the risk. We’ll plan for big expenses and stop adding to the 401(k) when we really need the money. We’ll rethink it when we hit the ceiling on the amount we can borrow back from the 401(k).

Richard’s bottom line: Stacey is a financial genius. She should always manage the money. Borrowing to save makes perfect sense. We’ll start borrowing to save on Monday morning. Meanwhile it’s time to kiss and make-up.

(c) Copyright R. M. Starr 2006

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