Borrowing against 401(k)s: The real cost of 401(k) loans

Are you thinking of pulling out a few thousand dollars from your 401 (k) savings plan, and wondering if it’s worth it? If you go online, you’re likely to find some great 401 (k) loan calculators that you can use to estimate the true cost of a 401 (k) loan. All you do is plug in a few numbers and can get a clear idea of what it really costs you to borrow from your 401 (k).

While many plan holders might think that the “real” cost of a 401 (k) loan is just represented by the interest rate charged on the loan amount, the truth is very different. In reality, you could be losing much more than you think!

The case against 401 (k) loans

You desperately want to deal with a “situation” that’s been hounding you for a while:

• an extensive renovation for your kitchen or bathroom
• the purchase of a new car
• going for that much-needed vacation
• paying off a big debt

More often than not, your 401 (k) seems like the most tempting source for funding such “situations”. The money is there. It’s sitting around…just waiting to be put to “good” use!

We’ve all been there.

In fact, according to the National Bureau of Economic Research, nearly 37% of Americans have had outstanding 401 (k) loans over a 5-year study period. Over that same period, nearly 86% of them defaulted on their loans.

No matter how tempting it might seem to dip into your 401 (k) before retirement, it’s never a good idea. Here’s why:

Double whammy

Even though the money in your 401(k) is yours – you’re still losing out because you have to pay interest on the funds you borrowed. But here’s the kicker:

The interest you are paying is coming from after-tax money, which means you pay (tax) before you pay (interest) again – which sets your savings efforts back with a double whammy!

But that’s not the only time you’re losing out.

No more compounding

Not borrowing from your savings would have left your balance untouched. The balance would have continued to grow and earn compounded interest – tax-free. By borrowing and depleting your balance, your retirement nest egg now earns you less tax-free interest. It kills the compounded growth of your retirement savings!

No free money

Many corporate retirement plans have a matching program, which requires employers to top-up employee retirement savings contributions with matching funds. In some cases, employers may put in up to 100% of your own contributed amount. In effect, you are receiving “free money” from your employer just by saving for your retirement.

When you borrow from your 401 (k), most employer-sponsored plans will stop making matching contributions until you have repaid the loan in full. Your supply of “free money” from your employer stops as soon as you take that loan!

Double taxation

The beauty of a 401 (k) is that the money you accumulate is taxed just once – when you finally withdraw it after you retire. While the money is inside the 401 (k), it is sheltered from any forms of taxation and continues to grow tax-free.

But that all changes when you borrow from your 401 (k).

The loan amount is taxed first when you borrow it. You then have to repay it back into your 401 (k). Then, upon retirement, when you finally take money out for your personal use, those withdrawals are once again taxed. This double taxation is like taking one step forward (on your path to retirement savings), and two steps backward!

No creditor protection

In some cases, you may have a temporary financial challenge – like owing money to a creditor for goods or services you may have contracted. You immediately think of your 401 (k) as a great source of financing those debts. Bad idea!

The beauty of a 401 (k) is that it’s legally protected from creditor claw-backs. That means even if you declare bankruptcy, your creditors can’t get at your 401(k) money like they can when they garnishee your wages. Your retirement money is safe!

Borrowing from your 401 (k) therefore makes no sense, because you lose out on the creditor protection that the law offers your 401 (k) balances.

Weighing it all

Sam J had a $120,000 balance in his 401 (k), and contributed $500 each month to his plan, with his employer matching the amount 100%.

Sam expects that his plan will return him an average of about 6% each year over the next 30 years or so of his working life.

A $15,000 debt nagged Sam into considering a 401 (k) loan as a means to pay the debt off. Luckily for Sam, he had access to an online 401 (k) loan calculator which told him exactly what the real cost of that loan would be. The cost was not just the 3.5% interest rate that he’d have to pay for the two years of the life of the loan.

When Sam ran the numbers, he determined that by borrowing $15,000 from his 401 (k) for two years, he could lose nearly $138,000 in savings by the time he retired.

Not just the $1,050 (i.e. 3.5% of $15,000 = $525 x 2 years) he initially thought he would!

As any savvy person would, Sam decided against borrowing from his 401 (k).

Avoid being sold on bad arguments

Many financial institutions will try to con you into ignoring the perils of borrowing against your 401 (k) balance. Some of the age-old arguments used include the fact that:

• it’s your money – why not make good use of it when you really need it?
• you don’t need to “apply” or “qualify” for a loan if you have sufficient funds sitting in your account
• regardless of your credit score – good, bad or indifferent! – you are almost guaranteed to receive that loan
• you’ll usually have a long time – often five years – to repay your loan

While these justifications might seem convincing at first glance, when you weigh them all rationally against the cons discussed earlier, you’re likely to come out on the wrong side of the argument.

Unless there’s a very compelling reason for you to dip into your retirement savings – to avoid bankruptcy or a foreclosure – you’ll do well to just leave it in there to grow. Thank you to the power of compound interest!