This is a transcription of the October 17, 2012 Mullooly Asset Management podcast about taking a loan from the New York State Deferred Compensation plan
Brendan: Welcome to the Mullooly Asset Management podcast for Wednesday, October 17, 2012. This is Brendan from Mullooly Asset Management and today we’re going to speak with Tom regarding the New York State Deferred Compensation Program.
Tom, you manage investments for over 300 different individuals who are participants in the New York State Deferred Comp Program. What are some of the hot button issues that you hear a lot?
Tom: Well, unfortunately there’s a lot of people looking to take loans from their deferred comp accounts.
Brendan: That doesn’t really sound good.
Tom: You’re right, and I guess if you have to borrow from somewhere, this is better than borrowing from a credit card.
Brendan: Right. Can you walk us through some of the pros and cons of taking a loan from your deferred comp account?
Tom: Okay, sure. Some of the pros are there’s no credit check. A lot of people have found over the last few years that when they go to apply for a mortgage or for a car loan or for any kind of consolidation loan, they needed a lot of information and it really was a tough process. With this, you’re actually borrowing your own money, so there is no credit check, it’s a pretty painless process to apply, and that’s all good.
You’re paying a rate on this money, the interest rate is less than what you’re going to find at most banks. Right now the rate is set at the prime rate plus 1%. Now, the prime rate at the moment, in October 2012, is 3-1/4%. So your loan is 4-1/4%, and the rate of the loan is set at the time the loan is issued, it doesn’t change. So it’s not a variable, it’s a fixed rate.
And you do pay yourself back this money, but, you know, some people say, “Gee, this is a really good thing, you know, you’re paying yourself your own money and you’re paying 4-1/4%.” But understand that you’re paying this loan back in after-tax dollars. So you earn the money, you pay the tax on it, and then you’ve got to pay this back. So that is a benefit, but it’s not that great.
The other benefit that I think people need to know is that there’s no pre-payment penalty. You can pay this loan off at any time in the future before the final maturity, before the end of the loan.
Brendan: Okay. So what are some of the cons?
Tom: Yeah, we got to cover that. The first thing and the most important thing is that the statements are really confusing. What I’ve found is with the folks that have loans against their deferred comp plans, you really need to check your statements, because your loan is included as an asset. Look on your quarterly statement, look on page two. It’s really deceptive, in my—and it’s very confusing. Let me give you an example.
I have a client who made $15,000 in one quarter this year in a three-month period, but in the same quarter he also paid down $6,000 of his loan. So his asset, the loan, went down by $6,000. He also made $15,000 in the stock market. But on the statement, if you just look at the bottom line, it looks like he only made $9,000. They really ought to separate the balance that’s owed on the loan in a separate category on a statement, but it’s not.
So be very careful when you’re reviewing the statements. If you have a loan against your deferred comp, it really does mess up your numbers, so be very careful about that.
The other thing is that’s kind of a negative is if you’re borrowing money as a first-time home buyer, you can pay that loan over 15 years, and that’s great. But for every other person who’s taking a loan from deferred comp, the loan has to be paid back in 5 years, that’s 60 equal payments.
So let me paint another picture for you. Suppose you were looking to consolidate loans, you have some of these credit cards where you’re getting charged 22% or 26%, and you go to pay this back. Remember that your minimum payments on your credit cards are going to be a lot lower than what you’re going to owe because credit cards, they calculate the minimum payment over a 30-year span, some of them even longer. However, the loan has to be paid back in five years, so your payments are going to be higher than you would have with a credit card and, you know, if you run into a pickle some month and you can only pay the minimum on a credit card, you can get away with that for a month or two, no problem. But once you get locked into a loan with a 5-year schedule, 60 equal payments, you can’t miss that, because here’s the problem. Once you fall behind on your loan with deferred comp, if you fall behind for 90 days, the entire unpaid balance of the loan is going to be considered in default. And a loan in default is taxable income to you. So it’s going to be a distribution from your plan. You don’t ever want to get in a situation like that.
So be very, very careful, you know, you can only have one loan at a time, so you want to make sure that this loan is going to cover you for the next couple of years. It’s not like you can go back next year and say, “Hey, I need to borrow more.” You’ve got to finish that loan before you can take out another loan.
There is something else, too. The payments for the loan don’t come out of your paycheck. They don’t come through payroll, they have to be from an outside source, so the money for your monthly payment for the loan has to come from a bank account, from Excel, from some other credit union, some other account that’s outside, and it has to be paid back in. And you do set that up at the time of the loan, but it is something that you need to know, it’s not going to be coming out of your paycheck.
And there’s lots of other things that you need to know with these loans. The most important thing is if you’re thinking about it, you should really give us a call and we’ll be able to answer a lot of your questions.
So while we didn’t mention any specific securities in this podcast, you need to know that none of the securities that we mention in any of our podcasts and any of our videos, they don’t represent a past specific investment of Mullooly Asset Management. And so we usually like to close by reminding everybody that none of the securities or actions that we mention in this podcast should be considered investment advice. And quite frankly, if you’re relying on a podcast for investment advice, I want to tell you, I think you might be making a huge mistake. We strongly urge all of our listeners to consult with their investment advisor before they make decisions that involve financial planning or to buy or sell any investment.
Now, if you don’t have an investment advisor, we’d be happy to answer whatever questions you have, there’s no obligation. You can call us at 732-223-9000, or you can find us on the web at Mullooly.net, that’s spelled M-u-l-l-o-o-l-y.net.
So, Brendan, we do get a lot of questions from folks looking to borrow money from their deferred comp accounts and there’s always lots of questions, and these were some of the major topics.
So we’ll look for more of your questions and see everybody back next week on the podcast.
You can download this week’s podcast about taking a loan from your New York State Deferred Compensation plan on iTunes for free!