If you’ve ever read my back-story, you probably know by now that I’d really like to be a stay-at-home mom, but it’s not possible because we had six-figure student loan debt. To make matters worse, I earn more than my husband. My husband has felt really terrible about the situation and, at one point, offered an attractive-sounding “out”. We could use a loan from our 401(k)’s to pay off our student loans, thereby allowing me to stay home. I really liked the way it sounded – borrowing money from ourselves to pay off our own debt, but then I did more research and I’m here to tell you there are 7 reasons it’s not a good idea to borrow from your 401(k):
1. Losing Out on Compounding Interest
The reason that retirement accounts work is the ability for interest to compound. You put in relatively little money every paycheck, but you watch it grow over time as interest starts to take hold. By taking money out of your account – even if you pay it back – you are losing portion of time that interest compounds. In other words, you actually cost yourself money.
2. Possible Loss of Future Contributions
Since borrowing from your 401(k) is a loan, you must come up with funds to pay back the loan, often starting from the very paycheck after the loan was initiated. If you had financial problems before, causing you to need the loan, where will the payment come from? Many people find that they have to forgo contributing to their 401(K) during the loan repayment period. So, not only did they lose out on compounding interest, but the account basically stalls.
3. Possible Inability to Pay Back the Loan
If you lose your job (or decide to leave), you will be responsible for paying back the loan within the next 60 days. If the loan is sizable and financial hardship caused the need for the loan, it’s unlikely you’ll easily pay it off. This is one of the scariest scenarios about 401(k) loans, in my book.
4. Increased Tax Liability
Your contribution to your 401(k) was made pre-tax. That means, when you take any sort of disbursement from your 401(k), it will be taxed. If I don’t convince you not to take a withdrawal from your 401(K), this is at least something to consider when you initiate your loan – you will owe more in taxes.
Not only will you be taxed when you take the loan, you’ll be taxed again. You see, you’ll pay back the loan and then, when you retire, you’ll take a disbursement and pay tax again. Does this really offset any interest rate you are paying on your debts (especially when you consider the potential loss of earnings accumulated in your account)?
6. Limits on Loan Size
Generally speaking, you will not be able to borrow more than $50,000 from your 401(k). In our case, borrowing $50,000 from both of our 401(k)s wouldn’t have paid off our student loans (though, it would work now). It hardly seemed worth it to us to trade one debt for another, especially when it wasn’t an equal trade.
7. Decreased Motivation to be Financially Accountable
The number one reason I decided against a 401(k) loan was because I’d become less financially accountable. I knew we could conquer our debt quickly if we made a plan (a budget), sold everything we could, and cut back on all spending. And it wouldn’t hurt to find ways to earn extra money, either. The motivation would mean that our 401(k)s would actually stretch further when we actually wanted them, meaning a possible early retirement.
Those of us who consider 401(k) loans do it for a variety of reasons, and there’s sometimes not a cut and dried answer to all those scenarios. If you decide that the loan is still for you, take the smallest loan necessary and pay it back as quickly as possible, trying not to cut into your retirement contribution in the process.