Tuesday, July 13, 2010

8 Reasons to Never Borrow from Your 401k Retirement Plan

I was browsing the comment section of my last post and came across a comment by Mogul in Training. As I was explaining to a previous poster, where I would be getting the money to pay for my house, she chimmed in and raised a great point. Always check with a professional before you borrow any money.

I am currently aware of all the risk that are involved, as I have taken out loans before (pre Dave). However I want to share with the rest of blog land why its such a bad idea. There are plenty sites out there, that will tell you "oh yes go ahead and borrow from your 401k" but trust me they aren't giving you all the pros and cons. So I was able to pull a site that gives ALL negatives. Why would I do that you say? Because I don't want people borrowing money just randomly. Even in my situation, I am looking for ways to lower the amount or just allow the home to foreclose (which I will probably explain the ramifications of that in a later post). Bottom line is it should be a LAST resort, my advise.. .JUST DON'T DO IT, but if you need real reasons here you go: This information comes from 401klookup.com

8 Reasons to Never Borrow from Your 401k Retirement Plan
(March 4th, 2008)

According to a study conducted by the Employee Benefit Research Institute in 2005, 20% of all 401k investors who were eligible for borrowing from their 401k plans (taking out 401k loans) did so. The average loan option exercised in 2004 was $6,946 which is about 1/2 of the average debt of households in America (excluding mortgage debt). The $6946 figure represents the following percentages of peoples' total retirement savings.

Age % of Total Savings
20s 25%
30s 20%
40s 22%
50s 11%
60s 9%

As you can note from above, as the person gets older, he has more retirement savings and tends to borrow less from his/her 401k plan. However, people in their 40s borrow about 2% more than people in their 30s, anyone have a logical explanation for this? Post your comments below if you do! And while it is good that as the person gets older, he tends to borrow less, it is not advisable to borrow from your 401k at all! We will go over 8 major reasons why you should never borrow from your 401k.

Some financial advisors might tell you that borrowing from your 401k is better than using your credit cards or taking out a commercial loan with higher interest rates. They also say that when you repay your 401k loans, you will be repaying interest to yourself, and not some bank. While this is partially true, in the long term, you would be way better off accumulating your savings and gaining compound interest, rather than reducing your principal amount by borrowing money from it.

1) Your Savings Growth is Reduced

If you take out a 401k loan, most plans have a provision that you cannot make any more contributions until a certain percentage of the loan is paid back. Some plans may even have a provision that states that 100% of the loan amount must be repaid! Added to that, even if your plan does not have a repayment provision, you may not be able to afford to keep up with your 401k loan payments and make additional 401k contributions (that you were supposed to make every month anyways). This significantly reduces your ability to grow your 401k savings. The whole point of 401k plans is to save for your retirement, by withdrawing any amount of money from it, you are really defeating the purpose of the plan!

2) You Are Losing Money

Every monthly contribution that you miss also misses the growth & appreciation that is available from the stock markets, bond markets as well as commodities futures markets. Furthermore, you are also missing the power of compounding interest on your total principal balance. The low interest payments that you are paying to yourself is likely to be insignificant compared to the appreciation & returns on investment that is available in stocks/bonds/commodities markets. Also, the money you are paying yourself will be after-tax. For every $1 you earn, your ability to repay the loan will only be $0.78 (considering you are in the 22% tax bracket). Also, that $0.78 that you have to repay yourself will be taxed AGAIN when you retire and withdraw your money from your 401k. You are pretty much getting beat down by the double taxation & losing the power of compounding interest, you do not want that!

3) Time is Not In your Favor

By making monthly contributions to your 401k, the idea is that over the long term, your money will grow substantially and accumulate the power of compounding interest. Compounding interest calculators state that your money will double every 8 years if you invest diligently and with discipline. Most 401k plans allow loans to be held for up to 5 years. If you used a 401k loan to purchase your home (or finance for a down payment on the home), you are losing the ability to double your money in 8 years average. What's more, you will lose the power of making additional contributions & more growth opportunities & returns on investment. Over time, your 401k balance will never reach its maximum potential and the greatest sum of money you could have had!

4) Unable to Repay the Loan? More Trouble!

If you get yourself in a situation where you cannot repay the loan, it will be considered a taxable withdrawal and you will be subject to income taxes. This is in addition to the 10% early withdrawal penalty you will have to pay for your withdrawal.

5) Quit Your Job? Repay the Loan!

If you quit your job with your current employer, the 401k plan administered by your employer will require you to repay it immediately! Thus if you have a 401k loan, you will be stuck at your current job for as long as you do not repay the loan. This is because if you quit, you will have to come up with the cash to repay the loan. If you do not have that cash, you cannot quit your job. This might require you to pass up a better opportunity where there's more pay, challenge and career enhancement.

6) No Financial Cushion

You should borrow a 401k loan in the toughest of circumstances where you really have NO other source of funding, no family, no relatives, etc. If you borrow a 401k loan to pay off your credit card debt or to fund an exotic vacation, this money will NOT be there when you really need it in the toughest of circumstances. That is why we say, do not borrow from your 401k!

7) Living Beyond Your Means?

If you need to borrow from your 401k, this automatically creates a red flag that you are living beyond your means. If you cannot find any other way of making money other than borrowing from your 401k, you should revisit your spending habits and see where you are blowing up excess money.

8) Violates the King Rule of Personal Finance

Borrowing from your 401k violates the very important saying of "Pay yourself first." It is definitely a bad idea to violate this rule.

So there you have it. If I do end up needing the money, I will put myself on auto repayment for minimum $1000 a month payback, I can't spend what I don't have and once you set up auto withdrawl there is no turning back. I will be in debt longer than anticipated but who said all this was suppose to be easy? 2.5 years on a debt free journey isn't all fun and games and I made a commentment to see it to the end, in both good and bad, so thats what I intend to do.


Anonymous said...

I completely agree and regret having borrowed from mine not once, not twice, but six times. I have paid back three of the loans, one will be done in Oct. The last two in Nov 2011 and Dec 2012.

I did learn learn from my mistakes and won't do it again.

Everyday Tips said...

We borrowed against our 401k when we needed a little extra for a down payment on our first home.

I personally did not regret that decision. We had no problem still contributing to our 401k, there was no limitations on that. I was fine with paying some interest to myself instead of paying rent on a cruddy apartment. (We were expecting our first child, and a cute little ranch home became available. We could totally afford the monthly payment, but we just needed a couple thousand more for the down payment so we wouldn't have to pay PMI insurance.)

However, this method may not work for everyone, it all depends on how disciplined you are and what you are using it for.

Divine and Debt Free said...

Single debt: over the past 5 years since I have worked for my current job I have borrowed against my 401k about 4 of those years. I was using the money, to go on vacation, finance business ideas, pay bills ect.... at the time i had no financial clue, I just looked at it as a convient way to get extra cash without hurting me much (so i thought). It sucks having to borrow from it again after I just paid the darn thing off, but Im gonna deal with it as fast as possible.

Everyday tips: Knowing what I know now I wouldn't borrow against it for any reason other than this. I will tell people if you want to buy a house, save up, have a big emergency fund. People don't realize there will always be a house for sale and you can always own a house, it will just take time to save up. You may have been able to borrown only once, but there are people who think that 401ks are a means of extra income and I just don't want people opening that door. It has put me in a bondage that I really dislike.

Diana Perkins said...

While searching in Google I have found your blog, & I have to admit that your blog contains very informative contents for common visitors
So, I was thinking that if you allow me, I want to contribute an article for your blog as a guest .The articles will be fully unique, original & more than 400 words& based on personal story.

So, if you are interested , please send me your answer as soon as possible at diana.perkins1983@gmail.com.

waiting for your quick reply