Taking a loan from your 401(k) can be tempting. You put all this money in it, and it’s just sitting there staring at you while you struggle through affording your house, car and maybe a vacation every once in a while. Then you find out you can take a loan from your retirement plan, and hey, by the way, you pay yourself the interest. That doesn’t sound so bad. Certainly, better than taking out a personal loan or putting something on a credit card and paying the bank right, especially at only 4.25% interest right now. Well, not always.
Here are some major mistakes to avoid when considering a 401(k) loan.
- You stop making contributions – Fidelity investments says 15% of people who take a loan stop saving to pay it back. MarketWatch.com provides us with hypothetical borrower Jessica who makes $60,000 /year and had been contributing 6% to her 401(k). She is 25 years old and decided to take out a 5 year, $10,000 loan. She can’t afford to keep saving while paying back the loan for those 5 years. At a 7% average annual return, Jessica will have $381,772 less in her account when she reaches age 65 than she would have if she didn’t take the loan.
So, if you do take a loan make sure you keep contributing and taking advantage of your company match so you’re not sacrificing your retirement for it.
- You leave your job – If you leave your job and don’t pay back your full loan in the 60 to 90-day window, you are found in default and the loan becomes an early withdrawal subject to taxes and penalties. The more painful cost, again, is future gains. In Jessica’s case every $1000 withdrawn now is costing her $16000 at retirement in 40 years.
We’re not saying taking a loan from your plan is never right, but make sure you do it responsibly and avoid these mistakes that can be very costly down the line.