I have a loan with a 6.5% interest rate. Should I divert money into my 401(k) instead of prepaying?
The long term growth is not 6.5%, it's 10% give or take. But, that return comes with risk. A standard deviation of 14%.  Does the 401(k) have a match? And are you getting the full match? If no match, or you already top it off, the 6.5% is a rate that I'd be happy to get on my money. So, I would pay it off faster.  My highest rate debt is my 3.5% mortgage, which is 2.5% after tax. At 2.5%, I prefer to be a borrower, as that gap 2.5%-10% is pretty appealing, long term. Having a loan also represents risk.  IMHO you should retire the loan as soon as feasible in most cases.   JoeTaxpayer, as usual, raises a good point.  With numbers as he is quoting, it is tolerable to have a loan around on a asset such as a home.  While he did not mention it, I am sure that his rate is fixed. If the interest rate is variable:  pay it off. If it is a student loan:  pay it off. If you can have it retired quickly:  pay it off and get the bank off your payroll. If it is consumer debt:  pay it off.
I'll be happy to edit when you provide answers to the question I posed in the comments.  Given the choice (and I assume there is no other) I'd take a loan from the 401(k) vs a withdrawal.  You withdraw $40K. I'll assume 25% bracket as you're planning at least a $200K house. Hopefully, your taxable income is above $38K, the 25% line for singles. The tax and penalty is 35% total, federal. You net $26K. And you have $40K less in the retirement account. In 40 years, at 10% average growth, that's $1.8M you won't have in your 401(k). And as littleadv stated, no deposits for 6 months, meaning no matching. There's a few more thousand you'll lose.  You borrow $20K. Your 401(k) will see a return on the $20k that's better than the short bond account, 4-5% vs less than 1%. You are short $6K, but in return have paid no tax, no penalty, etc. I respect those who are strongly anti-loan, but even they would agree, this is the far lesser of 2 evils.   The above is pretty generic, there are better choices. But your CPA friend's advice is nearly as bad as it gets. By the way, the tax you'll save once you have the mortgage has nothing to do with that 10% penalty. Say you bought the house with cash (as many would be happy to do). You'd pay the penalty for the 401(k) withdrawal, but have no mortgage deduction. If you had the 20%, you still have a loan and the deduction, but no penalty for taking his bad advice.  My advice is to take that refund and use it to pay the loan faster. "There's a bit of confusion here.  Michael's article you linked is focused on the issue of post-tax 401(k) deposits. For those new to this, it sounds like we are talking about Roth 401(k) money. Not so. The Roth IRA was introduced in 1998, and the Roth 401(k) in 2006. Before '06, people had the ability to deposit more to their 401(k) than the pretax limit of $15,000 into the account as ""after tax"" deposits. My understanding is that these funds were analogous to the non-deducted IRA deposits for those outside the income limits.  Michael goes on the point out that now, with the addition of Roth 401(k) and Roth IRAs, there are folk with pre and post Tax 401(k) funds and trying to crack them for transfer to Traditional IRA and Roth IRA may be problematic.  Aside from a recent thread here, there are separate accounts for the Roth 401(k) and Traditional 401(k), and it's possible for the traditional to contain post tax money, which, given the recent introduction of the Roth 401(k) conversion, should be easily addressable." "I am in a different situation, because I earn more than I spend, but I have found that I need to make the money inaccessible if I want to really avoid spending it.  I used to just throw my paychecks into a high-yield savings account, but eventually the balance was large enough that a ""large purchase"" didn't seem like ""that much"" (because I would have had so much left in the account after the purchase).  It was way too easy for me to spend way too much. Now, I invest my savings automatically.  The obvious benefit is my money has a much higher growth rate than a simple savings account (especially with fed interest rates so low).  I invest most of my savings in 401(k)/IRA retirement accounts, where there are severe penalties for withdrawing prior to retirement age.  Then, I invest a significant portion to a regular brokerage account, where the money is invested in stock and bond funds.  This money is accessible within a few days of whenever I need it.  The remainder of my savings goes into a savings account as cash I can get to at any time.  All 3 accounts grow with every paycheck (market fluctuations aside).   This 3-tiered system helps me to categorize my savings as ""Never, ever touch"" (retirement accounts), ""Touch, only if I can wait 3 days and am willing to pay taxes"" (brokerage account), or ""touch whenever you need it, with no penalties"" (Savings account).  If my savings account grows too much, I'll move money from there to the brokerage account (where it has more growth potential).  The longer my money is invested in the brokerage accounts, the less taxes I'll need to pay when I sell/withdraw the funds, so that's even more incentive for me to keep those funds where they are. I have credit cards, so in my opinion, having to wait 3 days for funds from my investment account to become accessible is considered ""accessible in an emergency,"" because my credit cards can be used to cover a large purchase for 3 days, and as long as I pay it off within the grace period, there's no interest charged. tl;dr investing is probably the smartest way to both grow your money and prevent the urge to spend it right away.  My advice is to start with a 401(k) or IRA as soon as you can, since the younger you are, the more time until retirement that your money has to compound.  Investing $100 more a month can mean hundreds of thousands of additional dollars in your account when you're ready to retire." Given that money can go into the 401(k) pre-tax, and that once the   loan is paid off, the principal is restored, I'm having a hard time   seeing the downside of this approach. Am I missing something or does   it actually make sense in my situation? You're missing several things. Here's a list of what I could think of: You should make sure that none of these issues is a problem for you. "There is no equation. Only data that would help you come to the decision that's right for you.  Assuming the 401(k) is invested in a stock fund of one sort or another, the choice is nearly the same as if you had $5K cash to either invest or pay debt.  Since stock returns are not fixed, but are a random distribution that somewhat resembles a bell curve, median about 10%, standard deviation about 14%. It's the age old question of ""getting a guaranteed X% (paying the debt) or a shot at 8-10% or so in the market."" This come up frequently in the decision to pre-pay mortgages at 4-5% versus invest. Many people will take the guaranteed 4% return vs the risk that comes with the market. For your decision, the 401(k) loan, note that the loan is due if you separate from the company for whatever reason. This adds an additional layer of risk and another data point to the mix. For your exact numbers, the savings is barely $50. I'd probably not do it. If the cards were 18%, I'd lean toward the loan, but only if I knew I could raise the cash to pay it back to not default." It would only make sense to repay the HBP faster if you knew your marginal tax rate would be increasing in the future.  It sounds like that is not the case.  By repaying it sooner with borrowed money, you are paying extra interest and potentially increasing your marginal tax rate.  Probably not a good plan unless you know your taxable income will increase for other reasons in the next couple years. A few years ago I had a 5 year car loan. I wanted to prepay it after 2 years and I asked this question to the lender. I expected a reduction in the interest attached to the car loan since it didn't go the full 5 years. They basically told me I was crazy and the balance owed was the full amount of the 5 year car loan. This sounds like you either got a bad car loan (i.e. pay all the interest first before paying any principal), a crooked lender, or you were misunderstood.  Most consumer loans (both car loans and mortgages) reduce the amount of interest you pay (not the _percentage) as you pay down principal. The amount of interest of each payment is computed by multiplying the balance owed by the periodic interest rate (e.g. if your loan is at 12% annual interest you'll pay 1% of the remaining principal each month). Although that's the most common loan structure, there are others that are more complex and less friendly to the consumer. Typically those are used when credit is an issue and the lender wants to make sure they get as much interest up front as they can, and can recover the principal through a repossession or foreclosure. It sounds like you got a precomputed interest loan.  With these loans, the amount of interest you'd pay if you paid through the life of the loan is computed and added to the principal to get a total loan balance. You are required to pay back that entire amount, regardless of whether you pay early or not. You could still pay it early just to get that monkey off your back, but you may not save any interest.   You are not crazy to think that you should be able to save on interest, though, as that's how normal loans work.   Next time you need to borrow money, make sure you understand the terms of the loan (and if you don't, ask someone else to help you). Or just save up cash and don't borrow money ;) Withdrawing from your 401(k) may include a 10% withdrawal penalty. There are ways to avoid the withdrawal penalty for early disbursements. The idea is to reduce your interest expense by leveraging free loans (0% APR purchases). This will help you pay down your debt more.  If you have 0% APR on purchases, you can make purchases on things you already buy. Then use that money towards other debt, while making monthly payments on the 0% APR card. This way, you pay off the credit card before the 0% APR changes. You can then rinse and repeat on another 0% APR card offer. If your credit score is 800, you can do this multiple times. Citi Simplicity gives you 18 months 0% APR. Chase Slate and Chase Freedom gives you 15 months 0% APR. Others typically give you 12 months or less.