Pundits claim that your 401(k) balance is a less expensive way to borrow money because the interest rate charged is generally lower than the rates on a commercial loan. They also cite the fact that when you repay the loan, you are paying yourself back with interest, instead of paying a bank. Despite these claims, borrowing from your 401(k) goes against almost every time-tested principal of long-term investing. Here we look at eight major reasons why borrowing from your 401(k) is a bad idea.
1. You Are Not Saving
If you borrow money from your 401(k) plan, most plans have a provision that prohibits you from making additional contributions until the loan balance is repaid. Even if your plan doesn't have this provision, it is unlikely that you can afford to make future contributions in addition to servicing the loan payment. Because the whole point of having a 401(k) plan is to use it is as a way to save for the future, you are defeating the purpose of having this account if you use it before you retire.
2. You Are Losing Money
If you not are not making contributions, not only is the entire balance that you borrowed missing out on any potential growth in the stock or bond markets, but each future contribution that you are unable to make (since you have a loan outstanding) isn't growing either. The extraordinarily low interest rate that you are paying to yourself with your loan payment is likely to be a pittance in terms of return on investment when compared to the market appreciation that you are missing.
3. Time Will Work Against You
Long-term investing (such as saving for retirement) is based on the idea that by putting time to work on your behalf, your money will grow. Most calculations suggest that your money will double, on average, every eight years. 401(k) plans permit each loan to be held for up to five years or longer. Therefore, if the loan is used to fund a first-time home purchase, loan holders not only lose out on what should have been an opportunity to nearly double their money, but they are also left unable to make up for the lost contribution and growth opportunities. Over time, their balance is unlikely to ever reach the total that it would have reached had contributions continued uninterrupted.
4. You Could Lose Even More Money
Should you find yourself in a position where you are unable to repay the loan, it is treated as a withdrawal and the outstanding loan balance will be subject to current income taxes in addition to a 10% early withdrawal penalty if you are under age 59.5.
5. You Are Trapped
If you have an outstanding loan, most plans require that the loan be immediately repaid if you quit your job. So, as long as you have a loan, you are stuck in your current job and may be forced to pass up a better opportunity - unless you are willing to take the loan balance as a withdrawal and pay the 10% penalty.
6. You Lose Your Cushion
Taking a loan from your 401(k) plan should only be done in the direst of circumstances after you have completely exhausted all other potential sources of funding. If you take money from your plan to fund a vacation or pay off higher interest loans, the money won't be there to borrow if you really need it.
7. It Suggests That You Are Living Beyond Your Means
The need to borrow from your savings is a red flag - a warning that you are living beyond your means. When you can't find any other way to fund your lifestyle than by taking money from your future, it's time for a serious re-evaluation of your spending habits. What purchase could possibly be so important that you are willing to put your future in jeopardy and go into debt in order to get it?
8. It Violates The Golden Rule Of Personal Finance
"Pay yourself first" is the golden rule of personal finance. This rule considered a primary tenet of good financial planning, and violating it is never a good idea.
If the idea of taking a loan from you 401(k) plan crosses you mind, stop and think before you act. Instead of short-changing your future to finance your lifestyle today, consider re-evaluating your current lifestyle instead. Scaling back on your expenses will not only reduce the burden on your wallet, but will increase the odds that a sound retirement nest egg will be waiting for you in the future.