5 Reasons a 401(k) loan is a Bad Idea
There are several reasons that a 401(k) loan is a bad idea, I know some of them from personal experience. I personally would never do another one unless it was to avoid a foreclosure or bankruptcy and even then I probably wouldn’t do it. We decided to do one to remodel our new home. We had just bought a beautiful home on 10 acres with a huge shop but the main house only had two bedrooms and one was really a small office. There was an in-law suite attached to the garage but not the main living space. We decided to add a bedroom and playroom which would connect the in-law suite to the main house. At the time, a 401(k) loan seemed like the best option. We learned three months later when my husband lost his job that it was actually a horrible idea. Here are a couple of reasons why it’s a bad idea in general but also why it was a terrible idea for us.
1. The loan has to be repaid quickly (30-90 days) if you leave your job
If for some reason you are laid off, fired, or quit your job, the loan has to be repaid within a very short period of time. For us, we had 60 days to pay back the loan. It is very difficult to pay back $20,000 in 60 days when the breadwinner is looking for work. We didn’t have any options to repay that amount in that short of time, so it counted as income come tax time. We ended up owing around $6,600 in taxes the next year when we usually get back several thousand dollars. So in all, the $24,000 loan really cost us over $30,000 which doesn’t include losses in compound interest. If you are thinking “my job is secure, I’m not going to get fired”, my husband thought the same thing. Three months after the addition was finished, he was laid off after being with the company for seven years.
The terms of the loan depend on and are up to your employer. Most terms are pretty common but your employer may not follow the norms and change it. For example, the majority of loans can be paid back within 5 years. Your employer could have it set to a max of 3 years instead. They also decide how long you have to pay it back once you leave the company, no matter the reason for the separation. You could have to pay it back within 30, 60, or 90 days.
2. It is really a withdraw not a loan
When you take out a “loan” from your 401(k), you are really withdrawing money out of your account. When you do this, you are using your own money unlike when you take out a loan at a bank. So, for example if you currently have $40,000 in your 401(k) and you take out a loan for $10,000, your 401(k) now only has $30,000 in it. This is why when we couldn’t pay our loan back when my husband lost his job, we had a big tax hit the next year. The tax implications with it being a withdraw is a 10% penalty + your tax bracket. So, if you are in the 25% tax bracket and can’t pay it back, you are paying 35% on that loan just in taxes! That $10,000 loan is now costing you at least $13,500. This was a big thing that I didn’t realize when we did our loan. I thought it was a loan using the money in our 401(k) as collateral. I was very upset when I checked the account and the money was gone.
3. Losing compound interest
Since the loan is really a withdraw, you are losing stocks. This means that you are losing the wonderful magic of compound interest. You now have less money in your account to buy stocks and mutual funds to grow your money. For example, if you are earning 10% a year return, yes I know it may not be that much but it’s a nice even number, you went from earning $4,000 a year to $3,000 a year. Now that’s just the first year, if you left the $40,000 in your account you now have $44,000 during year two which is going to earn $4,400, leaving a balance of $48,400 a the end of year two. If you took out the loan and only started with $30,000 for year one, you now have $33,000 to start year two. At the end of year two you only have $36,300, so your money is growing much slower. So, that $10,000 withdraw has cost you $2,100 in earnings by the end of year two.
4. Changes in stock prices could cost you
Since you are withdrawing money out of your account, you are selling stocks and mutual funds in order to take the money out. As you pay the loan back, you are buying stocks and mutual funds back. Considering the time it takes to pay the money back, the stock market will have changed since you sold the funds. Generally speaking, the cost of those funds are going to be higher than when you bought them originally or when you sold them.
5. You’re paying taxes on your money twice
Since most people have a pre-tax 401(k), the money that you are borrowing was not taxed initially. When you make your payments though you are using money that you have already paid taxes on. Whenever you withdraw the money come retirement age, you will pay taxes on the money again. Depending on what your tax rate is when you withdraw the money, you could be paying an extra 25% or more in taxes. So, on top of loss of interest earnings, that loan cost you another $2,500 or more in taxes.
Generally speaking, the withdraw is going to cost you way more than the original loan and is a huge risk. Any debt is a risk but the risks on this type of loan are higher in my opinion than a bank loan.
Considering that we are debt-free, I am not going to advocate for you to take out any type of loan but I hope that I can at least share my experience so that you don’t make the same mistakes we did. I hope that these reasons are enough for you to reconsider taking a 401(k) loan unless you are in dire circumstances. If not, then at least you are more aware of what a 401(k) loan costs you in the long run.