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 rights, borrowing from your 401(k) goes against almost all time tested
principal of long-term investing.
There are eight major reasons why this type of thinking is
short sighted:
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 an
oustanding loan) 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. If Your Financial Situation Deteriorates, 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 should one come along, unless you are willing to take the loan
balance as a withdrawal and pay the 10% penalty, which further compounds the
growth opportunities that you have missed by taking the loan.
6. You Lose Your Cushion
Taking a loan from your 401(k) plan should only be done in the
most dire 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 when 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, which is 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. Violating that rule is never a good idea.
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