What’s the worst idea of all time? I’ll share that later. But let’s launch this discussion on the 401k, shall we?
Before you tell me I just don’t understand, you should know that I’ve heard it all:
- Retirement’s a long way off. I need that money now.
- It’s my money. That’s WAY better than borrowing from a bank.
- It’s a low interest rate.
- My 401k sucks.
All of these may be true, but these are all still horrible reasons to borrow from your 401k plan.
First, if you have one available, your 401k plan is the #1 place to save for retirement, unless you’re one of the small percentage of people who are eligible for a traditional deductible IRA AND a 401k plan.
Second, as you learn just HOW a 401k loan works, you’ll sour on the idea in a hurry.
So, let’s start the souring process.
The Truth: You Aren’t Borrowing Your Money
First, the amount you can borrow from a 401k varies widely from employer to employer. However, the most you can borrow is half of the money in your 401k plan. Why? Because what you’re really doing is borrowing money from your 401k provider, who holds the amount of your loan until you repay it with interest.
Why is this important? The idea that you’re borrowing your own money is flawed. All of the bogus “pro-loan” arguments roll from this technical detail. Just like anything else, you’re paying back on fun you’ve already had instead of saving for fun you hope to have tomorrow.
You Pay Yourself Back Interest – La De Da
This is correct, but the key here is in what the loan actually is costing you. While you had the money in your hand, the market was probably going up. Do you know that the stock market goes up about 70% of the time? Ouch. Your odds of “winning” against a market going up are pretty bad.
The interest rate on the loan, according to many sources, is usually the prime rate plus one or two percent. However, while you’re earning that money, your money could have been earning more.
Here’s an example: Let’s say that in 2008 Martha wanted to buy a stock car to race on Saturday against Penny and Louanne. The car was going to cost $10k. Luckily, she had $20k in her 401k, so because critical thinking isn’t Penny’s strong suit, she decides to borrow that cash from her S&P 500 index fund (she listens to a great podcast that told her this would be a good option). She then paid herself back the loan plus a hypothetical 3% interest on the loan per year. Because she’s paying back the loan she decided to STOP contributing to the 401k (can’t afford both the loan payment of $2,156 AND new contributions). How about this….we’ll show her adding new contributions of $2,156 once-a-year in the “what she could have had” column as well. That should make the loan look like a better option, shouldn’t it?
Jan 2008 – Could have had: $20,000 Had: $10,000 plus a shiny new race car.
Jan 2009 – The market LOST 37% Could have had: $14,756 Had: $8,456 plus a (now crashed) race car AND loan payments.
Jan 2010 – S&P 500 gained 26.46% Could have had: $20,816 Had: $12,417
Jan 2011 – S&P 500 up 15.06% She could have had: $26,107 Had: $16,443
Jan 2012 – S&P 500 up 16% She could have finished with $32,440 Had: $21,230
Difference? Martha would have been ahead by $11,210 or roughly 35%, had she skipped the loan. Ouch.
BUT that’s not realistic.
The realistic question is this: What does this mean to Martha’s retirement? Let’s take out the calculator again: If she’s 30 years old and plans on retiring at 65, at 8% interest that $11,210 is really $165,743.71.
What could you do with an extra $165,743? I’ll bet you could do a lot more than buy a $10k race car.
It could have been scarier: now her loan is paid off. It would have gotten worse had she kept borrowing: the next year the S&P 500 gained a monster 32.39%, and as you know it’s hitting new highs as we write this in 2014.
The point: you lose a ton of money when you borrow from your 401k plan.
Some planners make a big deal about the fact that you’re paying pretax money with aftertax dollars when you’re borrowing from a 401k. If you do the math, it all equals out….but this fact still grinds me.
What if you lose your job? That’s horrible. You have to either pay the loan back RIGHT NOW or it’ll count as income TODAY (and you can either try and take savings to pay the tax bite now or just suck it up at tax time). By the way, that money was pre-tax. You’ll owe a 10% early withdrawal penalty unless you’re over 59 1/2 or can find a way to call it a “qualifying event.” (Good luck)
I hope you never end up borrowing from a 401k plan. I ALWAYS recommended getting into credit card debt over using 401k money. That’s how ugly these loans are.
Oh yeah, I promised to tell you what was worse than a 401k loan? Here it is: taking a 401k loan to make a down payment on a depreciating asset like a car or (worse) a boat. Now you have 401k loan payments, payments on an asset that’ll depreciate AND a cash flow squeeze that I’ll bet will force you to lower your new 401k contributions.
Mortgage Sign: WoodleyWonderWorks