Here’s a great example of how “smart” money people often get lost in the details, and make bad choices (or in this case, bad recommendations to people). I’m talking about a recent SmartMoney article where they espouse the virtues of borrowing from your 401k.
The basis for their recommendation that “never borrow from your 401k” is outdated financial advice is that they believe a 401k loan is:
“The most affordable loan available.”
This is true – up to a point. They’re mostly just looking at interest payments, and ignoring all the other effects and risks of a 401k loan. When you simply examine the interest owed and compare that to other loans, then a 401k loan does seem like a clear winner.
According to the Profit Sharing/401(k) Council of America:
“Approximately 90% of employers offering 401(k)s permit employees to borrow from them, according to the PSCA, and the loans can last for up to 15 years.”
But just because you can do it, doesn’t mean borrowing from your 401k is a good idea.
Let’s look at this a little deeper..
Why borrowing from a 401k is a good idea (sort of)
The pundits at SmartMoney would have you believe that borrowing from your 401k is a smart money move, at least in the current economic climate. But does this really make sense beyond the simple comparison of interest paid after taxes?
Here’s SmartMoney’s spin:
“Advisers, for example, typically discouraged clients from taking a loan from their 401(k) – but this is now the cheapest way to borrow money, with the average rate at 4.25%, lower than most personal loans”
Their cursory comparison of interest breaks down like so:
- Average credit cards interest rate: 14%
- Average home equity lines of credit interest rate: 5.22%
- Average 401k loan interest rate: 4.25% (“prime (currently 3.25%) plus 1%, “)
Some of their other arguments in favor of borrowing from your 401k are:
- The money you pay the loan back with goes into your 401k, instead of to a bank.
- Paying a 401k loan off is easier than other loans, because the contribution you would normally be making go toward the loan 1st.
Why a 401k loan is a bad idea
OK, so by those numbers, a 401k loan doesn’t seem so bad. But here are some things not considered:
- Time stops working with you, and starts working against you. When you stop saving for retirement, you put that day you can retire further off in the future – lengthening the time you’ll need to work.
- Increased taxes. You end up owing more in taxes due to the lost deduction when you stop contributing to the plan to pay off debts and other loans.
- Decreased gains. You lose much of the gains in your 401k because you have less money “at work” compounding gains for you.
- The entire loan amount will become due within 90 days should you leave your job or lose your job. Failure to pay that amount results in the outstanding balance being treated as taxable income and you get hit with an additional 10% early withdrawal penalty if you’re younger than 59 1/2.
- Welcome to servitude. Besides the very real risk of losing your job in a high unemployment environment, this is in effect making you even more of an indentured servant to your employer as you lose a significant amount of job flexibility. You will not be able to take a new opportunity at another company without a financial penalty (see above) if you cannot pay back your 401k loan in full first. Think about that.
Final thoughts
Well by now you can tell I’m no fan of 401k loans, but like so many things in finance there is no hard-fast rule here. Borrowing from a 401k may make sense for some people in dire straights, but even considering such a move should be viewed as a sign that you’re on shaky financial footing.
To me, a 401k loan is a last resort and even then only to be considered along with some serious soul searching and self evaluation as to how you got in the situation where this even sounds like a good idea to begin with.
The SmartMoney article claims that:
… right now, the cheapest bank for many borrowers—especially those who feel secure in their job–is their own 401(k).
But who really feels secure in their job right now?
They also say that you’ll be paying yourself back with interest instead of paying a bank. The implication here is that a bank would just be taking your money for profit in form of interest, while interest paid on a 401k loan is money in your pocket. But with a 401k loan I think you’re really only stealing from your future.
Besides the financial penalties discussed above, borrowing from your 401k sets you back on the road to retirement and for many people that leads to increased risk because they feel the need to “make up for lost time” and invest in more aggressive (i.e. risky) funds then they should.
Still, if you find yourself in a position where you’re being crushed with high interest debt and your retirement savings are at risk anyway (perhaps through a divorce settlement?) then it may be the path of least pain and get you back on the road to retirement quicker. Just think over the implications first.
It seems like there should be a breakeven point between commercial and 401k loans depending on tax rates, interest rates of each, projected 401k returns, etc. I’d love to see some more math around this.
As a gut feeling though I have to completely agree that taking a 401k loan is a bad idea because of your third reason – you have a very unpredictable repayment schedule when your employer can fire you at will.
No Debt MBA recently posted..Im glad Im not headed to law school
I suspect you are right about a break even point, but I think that it’s likely to be the exception rather than the rule. You can justify many financial moves with the right situation or assumptions (just look at investors in times of a bubble).
[...] [...]
[...] Debt Free Finance submitted a great article that very nearly was this week’s winner. In Dumb Money Tip from SmartMoney Mag, Joe addresses an all too common issue — a finance magazine giving out bad financial advice. [...]