Friday Financial Tidbit-Why 401(K) loans make me cringe

One of things I keep hearing and reading about more and more is the 401(K) loan. It seems like they are becoming more common in the past few years and that people are even recommending them to help with paying off other debt or buying a home.

Why 401(K) Loans make me cringeThere are a few reasons why I disagree with this advice and actually think that 401(K) loan can be quite harmful to your overall financial life. The reasons are:

  1. Risky downside
  2. Lost opportunity to grow money
  3. Not really paying off your debt

Risky Downside

The main reason I do not recommend them is because they have a very risky downside. If for some reason you leave your job, you have 60 days to re-pay the loan in full or the IRS considers the loan an early withdrawal.

This means you will be charged a 10% penalty, plus your tax rate! So you are probably looking at the government taking anywhere between 35-40% if you lose your job, either expectantly or unexpectedly.

I know, I know, your job is secure and you will not leave. But layoffs as well as unexpected illness do happen and the last thing you need is a $10,000 tax bill from the IRS when you are out of a job and have no money.

Lost Opportunity To Grow Money

Another reason to avoid them is the lost opportunity cost to grow your money. By loaning the money out to yourself, you are unplugging money from a fund that has the ability to grow more than the interest you are paying back to yourself.

If you take a $20,000 loan out over five years and pay yourself back 4%, you will have ~$24K at the end of the five years. But if you leave them in good fund that average 10% over the time frame, you will have ~$32K at the end of the five years. That’s about $8K or 33% more than if you had borrowed your own money and paid it back!

Never Paying Off Your Debt

401(K) loans are sometimes marketed as ways to help pay off your high interest credit card debt or borrow for a down payment. But in doing that are you ever really getting out of debt?

Not really, instead you are just shifting the debt to another source. Yes you may have paid your debt off at a higher interest rate or used the loan to help purchase a house with “good debt.” But the debt is still there. When it comes to debt, the interest rate is not the problem, it’s the debt that is the problem. All of the maneuvering in the world doesn’t pay off the debt, it just puts it someplace else.

My point is that I think the 401(K) should be used for its original purpose, saving for retirement. Using it as a vehicle for loans or emergency savings is a poor use of the 401(K).

Treating our 401(K) like a savings account will likely derail us in reaching our retirement savings goals because we will be constantly unplugging good funds and your growth will become stagnant.

I personally cringe when someone tells me about taking out a 401(K) loan knowing that there are probably better options out there. Today it might make it easier to take out a 401(K) loan but I’m worried about how that decision today will impact tomorrow’s balance.

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