7 Reasons Why Borrowing From Your 401k is Bad, Bad, Bad!

By glblguy

Retirement Life

Most companies, at least the larger ones, offer 401k programs. One of the perceived benefits of having a 401k is the ability to borrow money from it. On the surface this seems like a great idea. You get to take out a loan against your own money, and pay yourself the interest (generally prime + 1%). It also doesn’t show up on your credit score (I personally don’t care about my credit score, but I am sure many of you do).

If these were the only things to consider, than I would agree, great deal. But there are some significant downsides to 401k loans:

1 – You are borrowing against your future

With a 401k loan, you are borrowing money from your retirement account at, let’s say 7%. What you have to consider though is that you are giving up on average a 12% or so return, which is a difference of 5%. Over the long haul, this can have a significant impact on your final 401k balance when you decide to retire. The amounts are significant enough that I would suggest you run the math and actually see the projected difference, it can be pretty surprising.

2 – If you leave your job voluntarily or not, the full amount is due immediately

One thing many people don’t realize is that if for some reason you want or need to leave your job or worst case you get laid off the full amount of the loan is generally due in 30-60 days. This leads to my next point…

3 – If you can’t pay the loan back, the unpaid balance is treated like distribution

If for some reason you can’t pay back the balance, the unpaid balance is treated like a distribution. In other words in addition to income taxes you would need to pay on the money, you also have to pay a 10% penalty. This can obviously be a considerable amount of money.

4 – You pay double taxes

While the loan itself isn’t taxed, remember you are paying the loan from payroll taxed dollars. Down the road when you pull out of your 401k, you will again have to pay taxes on that as well, so essentially any money you pay against the loan is really double taxed.

5 – Starts a bad habit

In general borrowing from your 401k can start a bad habit. Most financial advisers will agree that borrowing from your 401k is risky and hurts your overall 401k value. Once you do this, you are more likely to continue doing it, and possibly using it to buy crazy stuff you really don’t need. It just starts a bad trend, and one that you should really avoid. Remember, you are borrowing off your retirement, your future.

6 – Some plans make you stop contributing while your loan is outstanding

Some company plans force you to stop contributing while your loan is outstanding. This can turn out to be considerable dollars lost, in particular on a longer term loan like the maximum 5 years.

Also, in order to be able to make the 401k loan payments, many people voluntarily stop contributing, or reduce their contributions to be able to pay the loan. Again, considerable dollars lost over the course of the loan.

7 – Some plans charge a fee for loans

Some company plans charge fees for the loan, and depending on the fees, this may make an already bad option even worse.
Final Thoughts

I am not completely against 401k loans, but the only scenario I would advise them would be in a complete hardship scenario where you need money and you have no other options. Worst case, you can’t pay it back and you just have to take the tax and penalty hit. Not a good option, but better than loosing your home, filing for bankruptcy, or having your wages garnished.

I currently have loans against my 401k, and kick myself daily for doing it. They are low priority in my debt snowball, but once paid off I will never borrow from it again. Just the risk of something happening where I either change or lose jobs and have to pay the full amount off is enough risk and worry for me to not ever consider it again.

Many times financial decision aren’t always about numbers, they are about giving you peace. Having loans against my 401k make me worry and don’t give me piece.

What are your thoughts? Anybody in favor or borrowing from your 401k? If so, why?

20 Responses (including trackbacks) to “7 Reasons Why Borrowing From Your 401k is Bad, Bad, Bad!”

  1. justin Says:

    A 401(k) loan can be a decent solution if you are going to borrow the money anyway, the interest rate is decent, the stock market is tanking or going nowhere fast and you have a stable job.

    Sure, lots of requirements, but they’re not impossible.

  2. glblguy Says:

    @Justin – The biggest problem is you have to pay them back within 60 days of leaving your job. So if you are suddenly displaced with 20,000 in loans you have to scramble to pay it off. I would only advise them in extreme circumstances.

  3. DragonLady Says:

    Actually, I can think of one good reason to get a 401k loan: the first-time purchase of a primary residence. One of the only reasons my employer allows a 401k loan is for the first-time purchase of a primary residence. In 2002 I got a loan of $12,000 (the balance of my 401k was considerably larger than that) for just that sort of purchase. In return, this extra money (added to my savings) allowed me to get the house with enough down payment to avoid the dreaded PMI (Private Mortgage Insurance, also known as “money down a rathole”). Mind you, I kept saving the same amount into my 401k WHILE I was paying off the loan, and the second I got the opportunity to “roll over” that loan into a new Home Equity loan, I did.

    Like all forms of debt, it’s all situational and depends on good judgement and lots of fiscal discipline. In my case, the loan was used to buy an appreciating asset, and said asset absorbed and eliminated said loan within a couple of years. (Still have lots of untapped, growing equity, too.) I can only wince when I imagine someone using a 401k loan to buy an overpriced $750,000 bungalo during the height of the housing bubble, then being “equity upsidedown” within the year…. :(

  4. glblguy Says:

    @DragonLady – What would you have done had you been displaced just after borrowing the money?

  5. DragonLady Says:

    You mean, if I got laid off or fired, and had to pay it back immediately? In that case, I would have swallowed hard, paid some with savings, and put the rest ($10K or under) on my unused, low-rate (6%), emergency-only credit card. The payments would have been a bit fierce, but it would sure beat the $4000+ in penalties I would have had to take if I yanked it out of the 401k. I admit, I was taking a gamble at the time, but my job was stable, and it was a good risk.

  6. glblguy Says:

    @DragonLady – See, that is my concern is the gamble, especially in today’s volatile job market. And yes I met laid off…they call it displaced where I work :-)

  7. Jim A. Says:

    I will just say that it worked out really well for me. I borrowed against my 401(k) for a downpayment on a house in 1999. I paid it off in full in 2003 when I refinanced into a 15 year fixed. So the earnings that I gave up were negative. The rate (4.875%) was less than my mortgage. Because the 401k loan that I used was NOT secured by the property, I never had to pay a day of mortgage insurance. So it’s a gamble that worked out very well for me.

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    Fears usually are nothing much more than a state of mind

  9. Sybil Venhorst Says:

    If they actually approve the application, I’d be surprised if they offered more than $250-$300. That’s pretty much their limit on "low score" applicants.

  10. Kelly Says:

    Sybil, they do not run your credit score to take a loan out of your 401k……if your companies plan offers loan options then it doesn’t matter your circumstances to take the loan. My husband and I used a 401 k loan to pay off a lot of outstanding debt to get us out of a bad situation…..and we obviously had bad scores at the time. Thankfully we got our outstanding debts completely paid off and now have great scores. The reason they didn’t care what our score was is that the loan is being paid back automatically out of my husbands pay check…..so in other words about $100 is taken out of his check every other week. With the interest rate very low and with him paying it back the way he is it will be like we never borrowed it at all. Also there was no other way we could get the debts paid like they were due to high interest rates. We were people who made mistakes in our early 20’s with some credit cards but live responsibly now in our 30’s…..it was the right choice for our family and we are very thankful we were able to do it.

  11. Eric Says:

    You do not need to pay back right away. You can set up
    Eft withdraws from your own bank account
    with your 401k plan administrator. I have been doing that for the past 7 months.

  12. d original Says:

    I have a question I owe the IRS and I was offered by my 401K plan that I have 5000.00 that I can remove that is not a loan it is just my money. I do however have to pay the taxes and use the amount I take as income for next year. Would it be better to make payment arrangments with the IRS and pay there intrest and penalties or to take the necessary amount less the 25% taxes they withdraw even before you get the check and pay the IRS off? If I take the 1000.00 I will have to add it as income next year. Please can someone advise the better move.. I have never owed the IRS and im scared to death

  13. Joe S. Says:

    I hope someone can respond with comments on this – I disagree with the article about double-taxation. You contribute to the 401(k) with pre-tax dollars. The money sits in your account and grows, tax-free, until you start to draw it out at retirement. Any withdrawals you take are subject to tax.

    401(k) loans are paid off by after-tax dollars, and then when you withdraw money at retirement, you are taxed on the “loan amount again”. Ummm…not really…? You borrowed money from yourself and paid it back with after-tax dollars – correct, but there is no tax effect on the loan amount if you paid it off in full before retirement. The whole double-taxation point is incorrect, in my opinion. If you borrowed money through any other kind of loan, you would pay that off with after-tax dollars as well…so I don’t understand the point.

  14. steve Says:

    I disagree – there is value in the loan. I have diligently tracked my 401k for a over a decade – there is less in 401k than I have contributed. so the “in the longterm it will work out” seems to me to be a lie. I have actually found that making my 401k contribution pre tax, and annually pulling money (a small set amount that I pay back in 1 year, has helped in the last 2 years. I am paying myself interest and using the money to fund my personal portfolio. in the event of a departure I can sell my stock to pay back any loan, and my personal rate of return over the last 2 years is almost 30%. while my large 401k balance continues to lose money. This strategy is not for everyone and requires carefully planning and monitoring and yes has some risk. I just find it humurous that I can grow my portfolio and yet the “experts” that manage funds for a living make huge salaries and bonus money, while I am not getting a return. I truly do not expect to have any more in my 401k when I retire than what I put in there (and I am hoping there will be at least that much.)

  15. Julian Malins Says:

    I have a considerable amount of credit card debt (amassed over the years from various unfortunate events; no new debt in the last 6 years!) and am on the edge of looking into bankruptcy relief. However, I have a substantial 401k account. I have been with my employer for several years and feel my job is fairly stable. I’m considering taking out small loans and repaying them back in short periods of time and applying the loans towards paying off my unsecured debt. The low interest (paid to me) and the scheduled repayment makes it a very enticing option. I’m 35 and feel I still have time to make up the loss in retirement money. Can you comment on my situation? I’d appreciate your opinion.

  16. Yeah yeah yeah Says:

    I see these articles all the time. I suspect they are being written by financial folks working the 401K business.

    Borrowing from your 401K plan works two ways:

    1) You pay yourself the interest. If I take out a normal loan all the interest and fees go to the loan maker.

    2) My plan shows the value of my stock growing even as I have borrowed against it. So how am I losing out on the “gains” from this stock? So…answer this…if my stock value DROPS during this loan period does my loan payment compensate? Answer NO! It just doesn’t work the way the people writing this article says it does!
    I call shananigans!

  17. Thomas Payo Says:

    wow, so much straight & useful information, few things I haven’t knew before, so thanks for it. Also there is pretty damn active discuss between members with good info as well, thank you!