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?
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