Danger is seldom absent in various types of loans

Tap your credit card? 401(k)? or your home?

Dollars & Sense

November 18, 2001|By Mark Schwanhausser | Mark Schwanhausser,KNIGHT RIDDER/TRIBUNE

If one needs to borrow, which loan is best?

Credit cards, 401(k) loans and home equity loans all have their advantages, and risks. In the worst case, these loans can leave you mired in debt, trigger taxes and penalties or even lead to the loss of your home.

We asked financial planner Bill Urban of Menlo Park, Calif., to compare the costs one would incur over the next three years by borrowing $10,000 from each of these loans. Here's an overview:

CREDIT CARDS

Pro: They're easy to tap. You can make minimal payments on the monthly balance. And they're unsecured, which can put the lender at the bottom of the list if you must file for bankruptcy.

Con: They charge interest rates that commonly run twice as high as home-equity and 401(k) loans.

Bottom line: $3,609. Plunking down $10,000 on a credit card is the most expensive option. By paying 3 percent of the balance each month at 16 percent interest, you'd pay more than $3,600 in interest over three years.

But that's not the end of it. You'd still owe nearly $5,500 of the original $10,000 debt.

HOME EQUITY LOANS

Pro: Interest rates have plunged, and you generally can take a tax deduction for the interest you pay.

Con: If home values sag, you could wind up owing more on your loans than your home is worth. The stakes are high if you default.

Bottom line: $1,514. We assumed you'd make no payments for three years, then pay off the loan. During that time, you'd ring up $2,329 in interest, but you'd get to write off $815 on your taxes if you pay a combined federal and state marginal tax rate of 35 percent.

401(k) LOANS

Pro: Interest rates are low, typically the prime rate plus 1 percentage point. There's no credit check. You borrow from yourself.

Con: The real cost of a 401(k) loan isn't the interest you pay. It's what you could have earned on your money by investing it in stocks and letting it grow tax-deferred. And, your interest payments face income tax twice: when you earn them and when you ultimately withdraw that money from your 401(k). That's almost $400 in our example.

Then, if you lose your job, you must either roll over the loan to a new 401(k) or pay off the balance of the loan. If you can't scrape up the cash in time, you accelerate the income tax on the balance and trigger early-withdrawal penalties (federal, 10 percent).

Bottom line: $1,666 or $4,175. It depends mainly on how secure your job is. If everything goes smoothly, the $1,666 in forgone investment returns and eventual income tax compares favorably with a home equity loan. But if you were let go after one year and couldn't repay the balance, you'd trigger nearly $3,300 in taxes and penalties.

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