The Reality Of 401k Loans
“Every time you borrow money, you’re robbing your future self.” -Nathan W. Morris
Saving for retirement is certainly one of the best financial decisions you can make in order to help your future self. Not only will it allow you to maintain an income after you stop working, but it will also allow your money to grow so that you can have more to work with when the paychecks stop coming in. One of the options that many 401k plans offer is to take out a loan when you need extra cash. I have opted for this option myself and actually still am in the process of paying the loan back. Today I want to share with you my story with 401k loans and the disadvantages that I only came to see after the damage was done.
When I took a loan from my 401k, my wife and I used the money to pay off our credit cards and some other debt that we had. Boy did it feel great after we made those payments and received the statements with the $0 balance! I felt accomplished. No more credit card payments! Woo hoo! Up until this point, we were struggling to keep on top of everything. Now that the balances were paid and the 401k loan payments automatically deducted from my check, I felt like there was nothing I needed to worry about anymore. I wasn’t trying to scale a financial wall anymore. (See “Stop Scaling The Wall“)
Reality Set In
A few months later, and after making those payments to the credit cards, I realized I didn’t really pay off my debt, I only transferred it. So rather than getting my paycheck and making $200 worth of payments to the credit cards, my paycheck was just $200 less than what I was used to. And now, since I am locked in to the loan re-payment term, I can’t even make additional payments if I wanted to! I’m stuck!
Ok, ok, so yes, with the 401k loans I am no longer paying interest to a creditor. In the long run, is it really worth it? My answer is no…and here is why. 1) Since the debt was only transferred, I didn’t really learn my lesson about using credit cards. This will certainly not help me in the future. 2) Now I get to see those repayment deductions on my paystub until the darn thing is paid off. (Oh and I cannot make any extra payments when I have money I can throw at it). 3) The growth rate of my 401k is now lower since my balance is lower. This may not seem like a big deal, but it certainly is.
The Breakdown
Here is an example of what a 401k loan may cost you on a 5-year loan (these are made up numbers). Let’s say you take out a $10,000 loan from your 401k. There is a one-time fee of $50, which is paid to the investment company. Additionally, you will have interest on the loan; let’s just say 4.5%. You may be thinking, “Well, on a 401k loan, the interest you pay goes back to yourself”. This is certainly true, but it can still have negative results. The reason for this is because that $10,000 you took out is not growing at the rate of the mutual fund. So if before the loan you are the essentially losing $450 or more per year. (This is using simple math, but the actual amount lost would be higher due to compound interest and growth).
My lesson here is please do not take on debt to pay off debt. With investments like a 401k, you are not borrowing from yourself, you are robbing from your future. Don’t make the mistake I made. I know it’s rough and may seem like an easy way out, but in the long run, you will see greater growth in your 401k and you will have developed a greater respect for your own money.
Note: This article originally appeared at Defeating Normal.
Category: Personal Finance
