When you are in a bind and need some money, taking a loan from your 401k plan sounds like a good idea. After all, you would just be borrowing from yourself. But there are many things to take into account before you take a loan from your 401k plan. In this post, I will walk you through these things so that you can make the best choice possible.
How A 401k Loan Works
As I noted above, a 401k loan is taking a loan out against the money you have saved for retirement. Not all company 401k plans allow for a loan, so your first step would be to find out if yours does. Assuming yours does, you have to understand the interest rate.
Most plans charge the prime rate (at this time it is 3.5%) plus one or two percent on top of that. So most people who borrow from their plan are looking at between a 4.5% and 5.5% interest rate on the loan. Once you take out the loan, over time you pay the money back, plus the interest.
On the surface this sounds great. You really aren’t going into debt and you are paying yourself the interest, not some other company. But here are some things to consider.
Borrowing From Your Future Self
While you aren’t borrowing from another company you are borrowing from yourself. Seeing as how little most people save for retirement, it makes the most sense to leave the money in the 401k plan and let it grow over time.
To piggyback on the above point, even though you are paying yourself 5% interest, the long term average return of the market is 8%. While 3% might not seem like a lot, it is in the long term. For example, assuming you had $100,000 in your account and it grew for 25 years, at 5% interest you would end up with close to $340,000. But at 8% over 25 years, you would end up with close to $700,000. That 3% makes a big difference.
On top of this is the lack of compounding. If you leave your money in your 401k plan, that full amount can compound upon itself the entire time. But if you take out a loan, you will have a smaller balance to compound upon, meaning slower growth and not ending up with as much as you could have when you retire.
Put another way, $100,000 is going to grow a lot faster than $50,000 even with you making the loan repayments.
Should you take out a 401k loan, you have to take into account your job satisfaction. This is because if you decide to leave your employer and you have a 401k loan, you have to pay all the money back within 30 or 60 days of leaving.
If you don’t pay the loan back, you owe taxes on the unpaid amount, plus a 10% penalty from the IRS if you are under 55 years old.
This is a huge factor that many people overlook. Most don’t have the resources to pay the loan back so they just take the tax hit. But it is a big tax hit. If you have $25,000 to repay and you switch jobs, and are in the 25% tax bracket, you owe $8,750 in taxes when you take into account the 10% penalty.
So what are your other options when it comes to taking out a loan? To answer this, you first need to know why you are borrowing money. If it is for a TV or furniture, you need to just save your money. It will take some time, but there is no need to go into debt for these items.
If it is for a car, see if you can buy a lower priced used car or get a decent loan from your local bank or credit union.
If you need the money for a house, think twice as well. Maybe take a little bit longer to save more for a down payment. On the other hand, look for a lower priced home to buy.
While I am not 100% against a 410k loan, I think you should seriously consider the issues before jumping in. Look at the long term impact of what borrowing the money will do to your retirement goals. You may find taking the loan means retiring at 65 instead of 55. You have to know these things and be accepting of them from the start.
Also be sure to take into account your job satisfaction. The last thing you want to do is to take out a loan and then switch jobs 6 months later. That tax hit will haunt you for years to come.
Finally, look at other, creative ways to borrow the money. It may mean you have to save a little longer but your future self will thank you for being patient.