401(k) Loans: Why Borrowing from Yourself Isn’t Free Money
Emergencies happen, and usually at the times we least expect. When you suddenly need a pool of money to cover an emergency (or maybe that remodel that you’ve been wanting), you might think to yourself, “Wait, I have a lot of money saved in my 401(k)…Can’t I use some of it?” At first glance, a 401(k) loan feels like an easy choice: low interest, no credit check, simple paperwork, and cash in your account almost instantly. And hey, you’re just “borrowing from yourself,” right?
Well, not exactly. There are some big trade-offs to be aware of before dipping into your retirement plan.
What You Give Up With a 401(k) Loan
The primary issue with a 401(k) loan is that you miss out on the effect of compounding interest that makes retirement accounts so powerful. In short, once you take the money out of the account, even though it will be paid back, you cannot gain interest on money that is not in the account. Yes, when you take a 401(k) loan, you pay yourself back over time (usually 5 years) plus interest. That requirement for interest is intended to help mitigate the negative impacts of the loan, but it does not eliminate them altogether.
In theory, if the interest rate on the loan is the same as or higher than your average market return over the duration of the loan, then you won’t lose money. The problem is that life is rarely that black and white.
Market performance usually outpaces loan rates. This means that even in today’s high-interest environment, you would likely still miss out on growth. Let’s work through an example. Say you borrowed $10,000 from your 401(k), which you paid back over 5 years at an 8% interest rate. You would put $2,505 back into your account annually for 5 years to repay yourself and cover the interest. If we use the past 5 years’ performance from T. Rowe Price target date funds as an example, anyone under age 60 averaged returns between 10% and 12% (and even the more conservative portfolio for people age 60, the returns were over 9%). Assuming a 12% average 5-year return, even after paying back the loan and interest, you would have earned $15,914, which is $1,710 less than you would have made if you hadn’t taken the loan. If you take out multiple loans over the years, those thousands of dollars of lost growth can compound to tens or hundreds of thousands of lost dollars.
Your paycheck will also be smaller during this time. It’s like having garnished wages. Loan repayments come straight out of your check every pay period until the loan + interest is repaid. That’s less take-home money to work with each month.
To make it worse, you’re repaying the loan with money that you have already paid taxes on. Then, when you eventually withdraw from your pre-tax 401(k), those same dollars get taxed again.
When Might It Make Sense?
Right now, you might be thinking, “Well this guy is just anti-401(k) loans!” and while I usually advise against it, there are a few limited situations where a 401(k) loan may be worth considering. For example, paying off high-interest credit card debt. But even then:
- Borrow only what you need
- Keep contributing to your retirement plan
- Look at other resources first (emergency savings, HSA for medical costs, or a brokerage account)
- Talk to a Francis planner to decide if a 401(k) loan is right for you
It’s Okay to Miss Out on Some Short-Term Growth.
Your 401(k) is meant to fund decades of retirement, not short-term spending. Treat borrowing from it like a last resort, not an easy fix. A much better option is to reduce your contributions until you have 3-6 months of living expenses saved up in a liquid savings account. You’ll miss out on some short-term growth, but if it keeps you from borrowing from your 401(k) or taking on high-interest debt, that short-term loss will save you money in the long run.
Did You Know?
Your employer sponsors this financial wellness benefit from Francis. The benefit connects you with down-to-earth financial planners who educate and advise on any money matters…without the sales pitch. We are exclusively engaged by employers like yours and have no investment products to sell, so you can feel confident that you will always receive objective advice.
Your financial planner will help you set priorities and achieve your money goals, without judgment or financial jargon. Know that all discussions are kept strictly confidential. This service is offered as an employee benefit with no per-session co-pays, so you can meet with a financial planner as often as you wish. Services are paid by your retirement plan or your employer.
Connecting with a financial planner is easy! Here’s how:
- Visit FrancisWay.com > Services > Participant Portal
- Call (866) 232-6457
Download the free mobile app (Search for Francis LLC)
This article does not constitute financial advice and the numbers listed above are for demonstration purposes only. Past performance does not indicate future performance and we cannot guarantee market returns.
