You won’t believe what I’ve been hearing at work lately. Fellow employees are borrowing from their 401k accounts. Why do people take out loans against their 401k accounts and borrowing from 401k accounts when instead they should be looking at doing a maximum 401k contribution? I don’t know if there are people out there giving advice to do this, but it’s probably one of the worst ideas I’ve ever heard of. In fact, I would peg it up there with not saving for retirement at all!
After listening to a conversation about how this is a great strategy in this recession, I had to set the record straight and educate my friends at work. Someone has to do it right? Well, to sum up the multiple conversations I’ve had, here are five of the reasons why you should never borrow from 401k.
If you do borrow, time is no longer your best friend
Money grows over time, everyone knows that. And if you are investing regularly, time is truly your best friend. I’ll take a known statistic for example. Most of the time, your money doubles every eight years on average. For someone who is investing and not tapping into their 401k plans like a savings account, this is great news. However, if you withdraw money from your 401k plan you are missing out on serious growth opportunities. There are many reasons people take 401k loans, but many Americans take out money for a mortgage. 401k rules allow for these loans to be taken out for up to 5 years, and up to 15 years for a home purchase. If you borrow from your 401k, you are missing out on opportunities for your money to grow among other things. Over the long haul, this could mean the difference between $50,000 and $500,000. I don’t know about you, but I don’t want to miss out on the potential long-term growth prospects for my retirement money.
Losing money is not fun
You wouldn’t throw money out your car window, now would you? Yeah, didn’t think so. So why do it with your 401k money? Because that’s essentially what you’re doing when you borrow from your retirement account. And don’t use the excuse that paying yourself back the interest is boosting your savings. The long term return on your money makes the average interest rates today look like chump change. Don’t buy into this and avoid borrowing from your 401k. And don’t let me get into tax implications. To repay a 401k loan, you are using after tax money from your paycheck, which means anything above and beyond the principal repayment will be taxed a second time when you make a distribution from your account. That’s a bum deal.
Like a bird in tar, you are trapped
While speaking with my coworkers, many did not realize that a 401k loan stipulates that if you quit or lose your current job, the 401k must be repaid almost immediately. In effect, this is a type of leash that could force you to stay at your job and prevent you from seeking other higher paying opportunities. I can’t imagine having this freedom taken away from me. Even worse, if you unexpectedly lose your job after borrowing a large chunk of your retirement plan you’re stuck with the bill. And if you can’t repay the loan you get stuck with then a big tax bill for the early distribution. Talk about making a bad financial situation even worse. Borrow from your 401k and you are at the mercy of your employment.
Makes you look like you are chasing the Jones’s
If you can’t live within your means and need take out a 401k loan for anything other than an absolute financial crisis, what does that say about your character and spending habits? This is a huge wake-up call. Are you managing your money well? Are you keeping track of costs? These are questions you need to ask yourself if you find yourself borrowing from your 401k for frivolous purchases. Is that LED TV or kitchen remodel really worth the sacrifice of potentially a hundred thousand extra dollars in retirement?
Don’t listen to Nike, just DON’T do it!
Look, is it really worth it? There are plenty of sources of income and savings. You could even open up a zero interest credit card if you needed a short-term influx of cash. Sacrificing future gains to make a purchase today is not wise and I highly advise against it. Instead, look at your lifestyle and evaluate your choices and decisions. Are you making bad ones? If so, seek out help. You will be glad you did. If you want to be living on a beach at 65, you will NOT tap into your 401k account.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.
Weighing the pros and the cons, it would be more favorable for anyone not to borrow from their 401k especially if you are living paycheck to paycheck. Unless of course, it's an emergency.
Actions have consequences. If you are willing to accept, and make up for it, then go. Come to think about it, it is your own money after all. Borrow them if you like. Just be sure that you are aware of the cost and you won’t complain or regret it in the end.
There are a lot of people who weren't to get out from debt during the recession, driving them to borrow money from their 401k account. But we are somehow recovering now and if you are thinking of borrowing money, you must weight your options first.
Borrowing from a 401k can be extremely helpful when purchasing a home!
First, you are paying the interest back to yourself and not some bank!
Second, in most cases, you do not have an accelerated payment when quitting one job for another
Third, you MAY be able to deduct the interest on your tax return (IRS says money borrowed from one asset for another 'investment' could be deductible)
This plan can potetntially save you hundreds of thousands if utilized with sound financial planning. You could prevent yourself from paying a higher mortgage interest rate or mortgage insurance by utilizing your 401k for a larger down payment.
Also, you said most 401k plans double in size every 8 years. Ever heard of the rule of 72? Just divide your term or interest rate in to 72 to determine the term or rate of which you will need to double your money. With your math, not counting contributions, you would need to earn 9% to double your capital. I do not see that happening in this age of returns averaging around 4-5%.
When you borrow the funds for a home purchase not only do you get a lower home mortgage rate and wipe out any mortgage insurance costs you are also paying a rate of return that may be tax deductible to yourself! It is a quadruple win!
This is playing the game with the bankers rules and utilizing the system to your advantage.
Please look me up with any questions.
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once in the debt hole, there is almost no getting out. 401(k) loans are a viable means of reducing revolving debt when banks will no longer lend. I am in that boat - a credit score of 760, yet my mortgage company will not roll my loan, no other lender will touch an "underwater" house, and banks will simply not consolidate. Two credit cards recently raised my rate to about 25%, even though they have never received a late payment.
So I borrowed from myself at 5.25% and paid those two off and cut the cards up. Combined I borrowed $17K, and took that money out of the volatile market and is is now "earning" me 5.25%, even if I am paying the interest to myself.
I believe the 401(K) loan is a savior and a blessing. I wish we could borrow more, if we have it in there.
Sandy, I am following your footsteps. I just switched jobs from one giant brokerage company to another giant bank. Since houses down here in FL are way cheaper compared to Boston, I am cashing 70% of my 401 to purchase a townhome. In the long run it may not make sense but being 44 and never borrowed a dime in my life, I think I will have good night sleeps knowing that at the end of the month I don't have to write a big check to the mortgage company. I consider myself a moderately savvy day trader; I will enjoy riding the NASDAQ waves. Good luck to all.
Okay, this if from the other side. I took out a 401(k) loan to pay for a home in full and it's been a WIN situation for me. Here's why:
1. I'm paying myself the interest and the rate is much more competitive than what I would have paid a conventional mortgage.
2. My repayment period is 3 years. Less than the minimum 5 + 1 ARM that hardly exists anymore or 10 year mortgage.
3. This helped me to save lots on money over what I would have paid a lender in mortgage payments. True, I could have paid all the fees and points and takes out a loan and paid it faster but then the cost would have outweighed the savings later.
Anyway I do agree with you though. I don't recommend people using their 401(k) as piggy bank ever, and I have the resources to pay off the loan now (yaaay) in case I find a decent job somewhere else. I should write a post on this!