by Art West

Created on: August 19, 2008   Last Updated: August 20, 2008

It is NEVER wise to borrow from your 401k unless it is to keep you from getting your house foreclosed on.

Why is it so unwise?

1) You are losing the interest that the money in your 401k would be earning if it were still in your account. You can easily average 10-12% interest in any decent 401k. You are paying yourself back at maybe 5-6% so you are still losing ground.

2) The interest rate/expense paid is not tax deductible.

3) Most 401k loans must be repaid in 5 years or less.

4) 401 plans can charge loan fees and annual service charges.

5) You are limited to loans of either 50% of your 401k balance or $50,000 which ever is smaller.

6) The interest rate that you are paying yourself will be similar to the interest rate you can find at a bank or credit union.

7) You are also putting yourself at risk because if you should ever lose the job you have when you take your 401k loan, you will have 60 days to repay it in full or be penalized. It will be as if you made a withdrawal from your 401k so you would have to pay a 10% penalty on the initial loan plus you would have to pay taxes on it.

Just for fun let's run some calculations. If you have $100,000 in your 401k and you leave it sit for 5 years averaging 12% interest. You will have about $176,200 in that account. If you withdraw $10,000 and pay that $10,000 back at 6% interest over 5 years, that same account will have $175,100. You just lost $1,100 not to mention the fact that you had to pay $10,000 back in just 5 years.

Using our example, if you were to lose your job, you would have to pay $1,000 in penalties plus probably around $1,000 in taxes. Now you would have lost your job, you would still owe on the loan, and most likely you would not have any money. You would have to come up with $2,000 plus whatever the balance is that you owe on your loan. Where will you find that money? Maybe you could get a loan from a bank or credit union. But now you don't have a job so that may be difficult. You could have saved yourself a lot of headaches and some money by simply going to a bank or credit union to start with.

In my opinion you should never take out loans except for your mortgage, but if you are going to take out a loan go to a bank or credit union. NEVER borrow from your 401k unless it is to stop your house from being foreclosed on. And even then there are other avenues that you should use first such as doing a short sale.

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