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The astonishingly high risk of a 401(k) loan

Taking a loan against your 401(k) can be

Taking a loan against your 401(k) can be a financial disaster. Photo Credit: Getty Images/iStockphoto / DNY59

If anyone tells you a 401(k) loan is a cheap way to borrow, they are both right and very, very wrong.

401(k) loan interest rates are low. But the way many Americans repay them spells disaster.

If you stop your 401(k) contributions to repay the loan, borrowing $10,000 today could cost you $190,000, or $1,000 a month in lost future retirement income, if you’re in your 30s. If you’re in your 20s, the loss could double to $380,000, or $2,000 less a month for retirement.

That’s assuming you repay the loan. If you quit or lose your job, chances are high that you won’t, triggering taxes and penalties plus the loss of future retirement income.

You can minimize the damage if you don’t reduce your 401(k) contributions during repayment. Let’s say Ashley and Jessica, both 25, take out five-year, $10,000 loans with a 5.75 percent rate. Before the loans, both contributed 6 percent of their $60,000 salaries and got a 50 percent employer match.

Ashley continues contributing $300 each month in addition to her loan payments; Jessica stops her contributions and resumes them after she pays off her loan.

After 40 years:

—Ashley’s nest egg is about $5,700 smaller than it would have been without the loan, according to the National Center for Policy Analysis’ 401(k) loan cost calculator, assuming 7 percent average annual returns. That reduces her monthly income in retirement by about $31 if she buys a 30-year fixed annuity with a 5 percent rate of return.

—Jessica has $381,572 less than if she hadn’t borrowed, or $2,048 less each month in retirement income, if she buys a similar annuity.

Borrowers are also vulnerable to default. People who leave their jobs usually must pay back their balances within 60 to 90 days to avoid default. The loan then becomes an early withdrawal, with taxes and penalties typically equaling 25 percent or more of the loan balance.

The bigger cost is the lost future tax-deferred returns. Assuming 7 percent annual returns, each $1,000 withdrawal means $16,000 less after 40 years.

Before you borrow from your 401(k), consider:

  • Are you using this loan to live beyond your means? Fix the spending problem before you create a retirement problem.
  • Do you have a plan to avoid default? If you have such resources, the next question is: Why aren’t you using those instead?
  • Can you keep up retirement contributions?

A reckless 401(k) loan could turn out to be the most expensive money you’ll ever borrow.

Many people who borrow from their 401(k) plan like the idea that they’re “paying themselves back” because the interest they pay goes into their 401(k) rather than to a lender. Interest rates on 401(k) loans are typically the prime rate, currently 4.75 percent, or the prime rate plus one percentage point. But that return is likely lower than what the money would earn if it remained invested.

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