Is it a good idea to barrow from your 401k? Some people say it is. I don’t agree and I’ll explain why.
As with any other financial situation it really depends on the situation, however, I cant imagine any situation that will make this look like a good idea. The people who say it makes sense to barrow from your 401k give two main reasons.
- The interest rate you get is much lower that you would get from a bank
- You actually pay yourself the interest.
Both of these are true but here are the reasons I think it’s a bad idea.
- The money you barrow is actually taken out of the investment so you are not earning the interest you were earning.
- If you quit or lose your job that loan must be paid back in full or you will pay early withdrawal penalties and taxes on the unpaid balance.
Lets say your 401k is averaging 6%. That is 6% that you get from someone else. You decide to barrow $20,000 from your 401k. That is $20,000 that is no longer making the 6%. Now you begin paying it back and YOU PAY 2% interest on the loan. So you are loosing the 6% that is being paid to you and you are taking an extra 2% out of your own pocket. In effect, you are loosing 8%. Some people would say that you aren’t loosing the 2% because you are paying it to your self. I can see their point but my point is the 6% you are getting from someone else and the 2% is out of your own pocket so you are truly not getting any interest on your money. Borrowing from your 401k can cost you a lot of money over time in interest you could have earned.
Now let’s talk about what happens if you loose your job. As I said earlier, if you loose your job you will be required to repay the loan in full. If you are unable to repay it, it will be considered an early withdrawal and you will be assessed a 10% early withdrawal pennalty plus, depending on your tax bracket, you will have to pay tax on any gain and that could be as much as 20%-30%. So you could have to pay as much as 40%, and possibly even 50% in penalties and taxes on the amount you borrowed and if you have to barrow $20,000 it is my guess that you won’t have $10,000 just lying around to pay the penalties. As you can see borrowing from your 401k can expose you to a lot of risk.
I recommend never borrowing from your 401k.