The Dirty Secrets of 401k Loans

Now that the holidays are over, it’s back to reality. For many of us – hopefully, not you – it means paying off all the debts you racked up from your extremely generous giving. Let’s just hope you had already budgeted for it and you were merely using your credit card to get the free rewards.

Regardless of whether you have debt or not, sometimes, unknowns pop up in our lives where we need to get access to money. If you don’t have it sitting in a savings account – which I’m sure you do if you’re an avid reader of this blog – you have to find it somewhere.

For some, it might be a loan from their bank, and for others, it might be putting it on their credit card – please, don’t do this. However, if you’ve done a good job at saving for your retirement at work, then you might turn to the 401k loan option.

Most of us have heard of 401k loans, and I would venture to say that even a few of you have taken out a 401k loan. But, is a 401k loan really the best option for you? I mean it does sound pretty good because you’re basically just paying yourself interest to take out the loan, right?

Let’s dig into what it really means to borrow from your 401k and the crazy effects it can have on your long-term retirement – your jaw might just drop.

The Good

The good is pretty simple and straightforward. Your 401k provides you an amount of money that you can borrow against if the need arises.

You don’t have to go to the bank, get a credit check, or fill out a bunch of paperwork. It’s actually the easiest way to borrow money because you’re basically just borrowing money from yourself. The money – collateral – is already there, so you’re just looking for access to it.

There’s also an interest rate attached to the loan, so you’re kind of paying yourself interest too – well, not really even though many people think they are, but we’ll discuss that below. However, for most 401k loans, the borrower that receives the loan interest is also the one paying the loan interest, which makes it a net-zero interest loan.

So, you’re not necessarily making interest on the loan, but you’re also not having to pay interest on the loan. You’re getting a 0% interest loan, which isn’t a bad deal – until you see the rest of the story.

I’ll also list being able to pay the loan directly from your paycheck as a positive. It’s automated and you know how we love automation at NextGen Wealth.

The amortization schedule is typically five years, and you can always pay more, or pay it off early without penalty. Flexibility and little restrictions are also a positive. However, these minor positives pale in comparison to the bad and the ugly.

The Bad

Now, we get into a few of the dirty secrets in borrowing from your 401k. Some of these, no doubt, will be quite eye-opening.

To start off, as mentioned previously, while you are typically getting a 0% interest loan, you’re still not actually paying yourself interest – as most people actually believe. You are earning interest on the loan, but it still costs you the interest you’re paying since paying yourself back for the loan just means you're receiving the interest in your 401k from yourself, but it also means you’re paying the cost of the interest as well. Sounds confusing, but what it comes down to is you’re not actually earning interest, but rather just getting a 0% interest loan.

Another negative to 401k loans is that most of the time, they have to be repaid in full within 90 days of separation from service. So, if you still have 15k outstanding, you’re going to have to come up with 15k to pay back that loan or take 15k out of your 401k to pay it off.

And, that’s when things get even worse. Once you take that 15k out of your 401k, it’s gone FOREVER. You’ve just missed out on the huge opportunity cost (compound interest) for the rest of your life.

This could literally mean tens of thousands of dollars you’ve thrown away. As you’ll see, opportunity cost is where the true ugliness lies when you borrow from your 401k.

The Ugly

Now, let’s get to the real down and dirty of 401k loans. Do you know that the interest you pay on this loan is made with after-tax money? While this doesn’t sound like much, keep reading.

Let’s say you pay 25% in taxes. Since the interest you’re paying is after-tax, that means you’ve already paid 25% taxes on that money.

However, and here’s the real kicker, when you withdraw that same money in retirement, if you’re in a traditional 401k, you’re going to have to pay taxes again. So even if you’ve moved down to a 20% rate, you will have paid 45% taxes on that loan interest!

Something else you might also be missing out on because of your loan is your employer’s matching contributions – that’s right, the free money your employer gives you for contributing to your 401k.

If the amount required for you to pay back your loan takes down your actual contributions into your 401k to 5% or less, then there’s a good chance you’re going to be missing out on your employer’s match.

The kicker here though is, even if you do want to increase your contributions so you can get your full employers match, that increase in contributions is typically redirected to pay down the loan, which means you still wouldn’t get the match – not all 401k loans are like this, but many do have this rule.

Missing out on your employer’s match means missing out on free money, which means missing out on the opportunity cost of the money – compound interest – for the rest of your life, which means missing out on tens of thousands, if not hundreds of thousands, of dollars.

Plus, this isn’t even taking into account the opportunity cost – again, compound interest – that you’ll be missing out on from money from the loan that will no longer be invested for the next five years (the life of the loan)

As you can see, 401k loans can add up to a LOT of money over time. Most of us don’t even think about these astronomical costs simply because it’s there and it’s pretty easy.

So, before taking out a loan from your 401k ever crosses your mind, ask yourself if it’s really worth it. I think not and there are definitely better routes to go to borrow that money.

This is a post from Clint Haynes, a Certified Financial Planner® in Lee’s Summit, MO. He is also the founder and owner of NextGen Wealth. You can learn more about Clint at the website NextGen Wealth.