Do NOT Do This!!

As I scrolled my Google feed this morning I saw a CNBC article that just shook me to the core. More Americans take 401(k) loans, an indicator of financial stress (cnbc.com)

The good news is that the article is sort of leaning towards this being bad, but not calling it for what it is. TERRIBLE!! They point to this being better than Credit card debt and state how you are paying yourself back in interest, but missing out on potential gains. So let's get down to business and look at this. I know because I did this. It was a mistake and one that I hated every paycheck, every month, and could not wait to get rid of it. There is a better option and it is not credit, but before I get there, let's look at what this is and why it is wrong.

A 401(K) loan is essentially borrowing money from your future retirement, up to in some cases 50% of your balance, and you pay the fund back over time (usually 5 years) via direct paycheck withdrawal. It sounds pretty good on the outside, essentially this is your money, but there are many things that people do not realize.

1) Your interest payback is probably 4-5% of that money when the market should be earning 8-12% depending on your fund mix. So essentially you are missing out on key compounding interest (I know in a down market this may work, but no one is that good at predicting the market, and over 5 years, it will come back and you will miss out on the gains). The good news is that you are essentially increasing your investment back to your 401k, but missing out on those gains during the time.

2) You absolutely cannot miss a payment. First, the withdrawal typically comes right out of your paycheck. Secondly, if it does not and you miss a payment, you now owe the government potentially the tax for early withdrawal. Depending on the loan this could be a hefty sum and could hurt.

3) You cannot leave your employer or be let go until that loan is paid back. This is the big one, until it is paid back you have to stay with your employer or take out a separate loan to pay it back ASAP should you be separated from your employer for any reason. If you do not, again, you are subject to early withdrawal penalties from the government.

No matter how secure your job is or your employer, the last one should be enough to get you to think about the situation. Now, as I said I made this mistake before. When I moved houses in 2012 I took out 30k from my 401(k) to support the sale and purchase of a new home, with a plan to pay this right back as soon as we settled the closing on the old home. Then we got into the new house and realized we needed about 30k worth of repairs/updates, so we kept the money and did the work. Thankfully, I was in a pretty secure job and never worried about losing my job at this time, I had no idea what the penalties were, but I did see my paycheck get hit every payday with the loan amount to go back. I can tell you when I found out number 3 above we worked hard to get this paid off as quickly as possible. I have no idea what I lost interest-wise during those years, but I can tell you 30k was a sizeable chunk and I'm sure I missed out on some key gains.

So what options do you have in an inflationary time, with a desire to buy a house at 7% interest rates? I'm glad you asked because you have several options.

1) Pause your 401k investing for a short period. Yes, I know you will lose out on compound interest. Yes, that is a fact, but if you are saving for a house or paying off debt, this will save you money overall! For one, the house is an investment and in the second case, you are reducing your interest burden on debt. No one likes to hear about pausing investing, but this is the best option. It will help you get after it, keep you focused, and get you back to investing sooner rather than later. Set the savings goal and figure out what you need to do to achieve it. Have a target in mind and start saving. If you don't want to miss out on that free employer match, just limit your investing to the match, but take the extra percentage (15% recommended investing - Employer match) and put it into a high-yield savings account.

2) Just wait!! Nobody likes to hear this answer, but ideally, take debt off the table and start saving. Just like step 1 above, set a goal and figure out what you can do to save for it. If possible, just cut some budget areas back to put that money aside and start saving.

3) Plan ahead of time. The article points to homes being the number 1 reason people borrow from their 401(k) and I believe if you look into the numbers I guess that people borrow for some of those large repairs or renovations. If you want to do this type of work you need to start planning ahead of time. Again just like above set a target and start saving. I strongly recommend against pausing the retirement contributions for this type of thing, unless you are up against a wall. For instance, if your roof is desperately needing to be repaired and you have not saved for it. Now would be when I would put a plan in place to pause and aggressively save, instead of borrowing and paying later.

I hope you consider these options. Do not borrow against your 401(K) and certainly do not put this on credit or personal loans. Live within your means, keep investing, and plan for future needs. As the Mandolorian says, "This is the way." Happy savings (especially at 4+%)