One of our clients needed funds to pay college expenses for his daughter and realized he could take a loan from his 401(k) account.
“It seems like a pretty good deal,” he said. “They only charge me 4% for the loan, there’s no other costs, and I’ll be paying interest to myself.”
All that is undoubtedly correct, but once we sat down to show him the true cost of the loan, and the serious hit he would be taking to his retirement plan balances, he realized it wasn’t such a great idea after all.
Borrowing only $20,000 from his 401(k), and paying it back with his own money over a five-year period, would actually cost him nearly $125,000.
To make up for the damage done to his retirement plan balance, he might need to work two extra years or more.
Why are these loans so harmful?
How can something that sounds so harmless be so damaging?
- Most people are already behind the eight-ball in saving for retirement. By taking money out of the 401(k), instead of putting it in, they’re just getting further behind.
- The loans are paid back by extra deductions from your paycheck. Most people stop their 401(k) contributions during the payback period because they can no longer afford them.
- You’re losing out on compounding by reducing the amount of money “at work” in your account. Plus, the interest you are paying yourself is usually less than what you could have earned on long-term retirement investments.
- If you lose your job, your loan will be immediately payable in full, putting you in a serious jam.
- If you need to borrow from your 401(k) in the first place, you may be spending more than you can afford. There could be better ways to come up with the money, starting with possible cutbacks in your own budget. (Take a look at our review of better ways to pay for college in a recent blog).
The takeaway: About one-fifth of all 401(k) participants eligible to take these loans, do so. They’re tempted by the easy access and seemingly low interest rates. Unfortunately, as is true with many other financial decisions, they’re making choices without knowing all the costs and trade-offs.