The Risk of 401(k) Loans
Many 401(k) plans have the option of taking a loan against the retirement account that is paid back over a period of a few years. While the borrowing rate is low and it is ultimately paid back to yourself, the costs must be understood before considering taking out a 401(k) loan. In the end, a 401(k) loan should be a last resort option because of how much you are taking from your future self.
Below is a great hypothetical situation of a 25-year-old who is earning $30,000 per year. We assume salary increases at a rate of 2.25% and a savings rate of 6% a year with a 3% match invested in a 60% stock and 40% bond portfolio. In this example, we take a $10k loan to buy a home at 32 and another $10k loan at 50 to help pay for college costs. We also take an early withdrawal at 62 of $10k.
While this is a pretty typical situation seen across the nation every single day, the ramifications over your career can be incredibly significant. By taking a loan, you are reducing the number of assets that are available to invest and utilize to pay back the loan over time.
We take the financial markets from 1975 to 2015 to show the impact of the hypothetical portfolio with a loan and without a loan. Over your career, you end up with 30% less which, in this example, can translate to more than a $500k difference which can dramatically change your ability to retire. While a 401(k) loan can feel like a safe and easy option to get cash quick, make sure you realize what the costs are and consider finding another way to save up for whatever you need.
*a version of this article first appeared on this site on June 13th 2016