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401(k) Loan bad for your (financial) health?

The June Kiplinger’s magazine ran an article, “Raiding your 401(k).*” It advises against borrowing from one’s 401(k) and cites a T. Rowe Price study suggesting that someone borrowing $10,000 for 5 years (at age 35) will be short $145,000 at retirement even after paying back the loan. At 10%, $10,000 would grow to $131,100 in 27 years, that’s just math. Maybe they think this guy will retire at 63, not 62. But he did not take a withdrawal, he took a loan. My 401(k) charges 6.5% for a loan, credited back to the account. This means a 3.5% hit to the return on that borrowed $10,000. The account will come up short about $900 for having had the loan outstanding. Still using the 10% return, the retiree may find he is short nearly $13,000 at age 62, certainly not $145,000. Someone at T Rowe hit the wrong key, and none of my friends at Kiplinger’s catch this?

Think about this, though, the story cannot just end there. I can make the case that what matters is where that $10,000 loan went. Did the person buy a plasma TV and sound system? Or did he pay off all his credit card debt (at 24%) and start fresh? I can add to this – perhaps he was paying $288/mo and would have done so for 5 years to pay off the cards, but now is able to pay only $196 to the 401(k) loan, and use the extra $92 as an addition monthly deposit to his account. He is in the 25% bracket, and deposits a full $123 (which is the gross amount that nets him the $92) to his 401(k) and it’s matched by his employer, dollar for dollar, so at the end of year 1 he has nearly $3000 more in his account which more than makes up for the $350 hit he has from the loan itself. By staying on this path, he’s actually ahead by over $150,000 at retirement time.

As with any example, your mileage may vary. There is just one point I’d like you to take from this post. In finance, there are few absolutes. For every person who uses their 401(k) loan wisely, there may be five who blow the money and run up their credit cards again. But just as I take issue with Dave Ramsey’s statement that ‘responsible use of a credit card does not exist’, I feel that there are wise ways to use loans, 401(k) or otherwise. While I admit that a short article appearing in a magazine cannot cover every possibility, the one missing (and most important question was ignored – what does the borrower do with the money?

Joe

*The article is not yet available on line. As soon as I am aware it’s accessible, I will link to it.

UPDATE – I made an error here. (I prefer to leave the error in tact, above, but add this footnote.) In fact, the article did state “assume contributions stop for the life of the loan, as usually occurs”. This would make the math work, although I still take issue with these assumptions. I plan to revisit this subject in a future post.

  • Carrie May 12, 2008, 10:59 am

    I have been hearing people talk about using their 401(k) to get out of mortgage trouble. My advice is— don’t. Most often people in mortgage trouble fall back into trouble… you will need that money for later… get out of mortgage trouble another way, any way! Just save that nest egg for your later years or you will be out of luck later!

  • JOE May 12, 2008, 2:39 pm

    Carrie, you may be right, but I believe every situation is different. Did one parent stay home to care for a newborn, and the loan will float them the time until both are working? Will the loan pay down high interest CC debt?
    Most important to me was the article’s math was wrong, by a factor of 10X.
    Thanks for visiting.
    Joe

  • JAL May 12, 2008, 2:50 pm

    Joe,

    That’s an excellent point about there being no absolutes with things related to finance. How true!

    But as far as 401(k) loans go…

    Without being able to see the T. Rowe Price study to verify their numbers, possibly they factored in one or more of the traps a 401(k) borrower could fall into?

    1. Some plans forbid contributions to your 401(k) when a loan is outstanding. The negative impact on the future value of the 401(k) should be painfully obvious… you not only lose out on the interest, but you lose out on any company matching.

    2. If you change jobs, the entire loan balance is immediately due. If you can’t pay it back right then, it’s considered a taxable withdrawal and future tax-deferred interest on that money is gone forever. In case of default, the loan balance remaining is taxed as ordinary income and a 10% early withdrawal penalty is added.

    3. Even if the 401(k) plan allows continued contributions and loan payments, if someone needs to take a loan from their 401(k) in the first place, what are the chances they’re in a position to continue making contributions? Not very good I bet.

    The pitfalls of taking out a 401(k) loan are significant enough, that despite the ease of doing so, for almost everyone it should be considered the absolute last resort for a source of financing.

    Just my $0.02. 🙂

  • JOE May 12, 2008, 4:51 pm

    JAL –
    Is (1) true? I know that after a hardship withdrawal there’s a period you may not make deposits, but was unaware that a company may use an outstanding loan o do this. Considering home loans ar allowed a 10 yr payoff, that would be horrible, indeed. If that’s the assumption, it should be spelled out.
    (2) absolutely true. Part of the risk in taking out the loan. No argument there.
    (3) again, agreed. As I suggest to Carrie, the use of such a loan should be well thought out, and only when the numbers are compelling.

    I googled a bit to find the T Rowe price study, and failed. I still believe there was a typo somewhere.

  • JAL May 12, 2008, 9:39 pm

    Joe,

    I agree that on the face of it the T. Rowe Price math just doesn’t work out, so the devil must be in the details. After reading your post I also Googled looking for the study but only found several articles quoting T. Rowe Price employees.

    Borrowing against a 401(k) seems like such a terrible idea to me, I almost hate to see it being discussed. Very thought provoking post. 🙂

    JAL

  • JOE May 12, 2008, 10:33 pm

    JAL – your (1) was correct – I reread the article, and it stated “assuming contributions stop for the life of the loan as usually occurs”. My bad. The math is correct even if that assumption is not. I will add a footnote to the post.
    Joe

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