Let's say I take out a $10k 401k loan at 6% interest. I then use this $10k to pay off a $10k debt at 10% interest.
The question is this. What is my savings in doing this? The interest I pay on the 401k load is 'paid' to myself, so I am realizing that gain. I am also realizing the gain in not paying the interest on the 10% debt.
Given this, how would I go about calculating the % that I am 'earning'?
Let's say both loans require only one payment per year, and you will pay off the loan at that time. Let's say your 401k earns 8% per year.
Status quo: After one year, your $10K debt becomes $11K, which you pay off. Meanwhile, the $10K in your 401k becomes $10.8K.
Alternative: You pull out $10K today and pay off the debt; but now you owe $10K to your 401k. After one year, you pay $10.6K to your 401k.
By taking the 401k loan, your payment will be $400 lower, but your 401k will end up with $200 less in it. You are $200 ahead, sort of -- the extra money is in your pocket, not in the tax-advantaged 401k.
However, the principal issue here is not the savings (which are unknown, but probably positive), but with the risk and other ancillary issues. 401k repayments are often structured by automatic paycheck withdrawal, lowering your flexibility. If you lose your job, or change jobs, and stop making payments, then very bad things happen. Your loan becomes an early withdrawal, which will be subject to taxes, penalties, and interest. This will wipe out your gains many times over.
There's several different factors to consider here:
You're avoiding paying 10% on the loan.
You're adding more money to the 401(k) account. It's possible that you're ending up adding more money than your contribution cap would otherwise be; I'm pretty sure that paying yourself interest doesn't count towards your contribution limit. However, I recall there being a rule that you can't contribute while you have a loan outstanding. (If anyone comments with a cite one way or the other on either of these points, I'll edit that in.) Also see the caveat in point 4.
You're putting in after-tax money. If it's a traditional 401(k), you'll have to pay tax again when you withdraw it.
You have the opportunity cost of whatever you would have gotten from investing it. It's tempting to think of this as an "interest-free" loan because you're paying money to yourself, but remember that your 401(k) account could have been investing the money somewhere else, and that returns on an outside investment is actual profit that you're getting from someone else, rather than "fake" profit you're getting from yourself.
There are several risks with a 401(k) loan. If you default, that's considered an unqualified distribution. If you lose your job, you may have to pay it back immediately.
The importance of points 2 and 4 depend on how long the money will be in there. The longer it's there, the more compounding, so the more the question of how much you're adding and how much you're losing out matters. The importance of point 3 depends on what tax bracket you'll be in when you retire. If it's a low tax bracket, then the second taxation won't be as important.
So, for a very (emphasis on "very") loose approximation of how much this is helping you, take:
10% - (6% * retirement tax bracket) - (the return you would have gotten for other investments)
That's not taking into account the compounding effects of the tax advantage; if you're feeling ambitious, you could try to add that in.
If you take a 401(k) loan which you pay yourself, and we assume your 401(k) makes 8% interest per year. Then your net savings are as follows: If you do borrow: Your change in wealth in the 401(k) is $600 Your change in wealth in non-tax advantaged accounts is -$600 Opportunity Cost to the 401(k) is -$200
If you do not borrow from 401(k): Change in wealth in non-tax advantaged accounts is -$1,000
Therefore if you borrow from your 401(k) you effectively save $400 in your non-tax advantaged accounts but lose $200 in opportunity costs in your 401(k). Depending on how much you make this could be a minor point or a major one.
Your "percent" gain is 10% but that is a naive way of trying to quantify it.
