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Why shouldn't I take 401k loans if I am paying myself back the interest?

Jan 04, 2012 by Toni from Kenansville, NC in  |  Flag
3 Answers  |  10 Followers
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4 votes

Because an amount equal to what you borrowed with be transferred from your investment selection to an interest bearing account - and you will lose market participation on that amount. Of course your investments can go down in the time period the loan is outstanding, in which case you will end up better off, but its extremely difficult to time the market in that way.

Historically, equity type investments have increased on about 70% of the trading days on record - declining 30 % ...so staying fully invested in your selection without borrowing is probably the best course of action.

Of course if you really need funds, the 401-k loan is certainly a better option for you than a credit card.

Best of luck!

View all 5 Comments   |  Flag   |  Jan 05, 2012 from Port Washington, NY
H

I “think” your math is good. You really wouldn’t be out much interest if you are just paying it right back in. And it seems you would be reducing your taxes. Though I am not particularly sure of the amount of tax reduction, it seems it would be based on your tax bracket, and other factors.
I am looking at the math another way though, and I too really struggle with why this is such a bad idea.
So I take out a loan for $50K from my 401K (example it currently has a balance of 200K, leaving it with 150K instead). That 50K loan is going to cost me $944/month for 5 years, a total of $57,500 to buy a $50K rental. But that property is bough outright, no mortgage. I will still have taxes, maintenance, maybe it isn’t rented all the time. But let’s say I manage a $400/month profit on this thing without a mortgage. Seems reasonable I think.
OK, so 5 years later. Instead of that 401K being worth ~$322K (assuming ~10% rate of return and excluding any additional investment to it out of the picture). With it earning the same rate, starting from 150K but adding in those $944/month payments, it will instead be ~$314K. And this did cost me $57,500 to pay back the loan out of pocket. So I am kind of down like $65K. But what has that earned me? Well about $24K in rents so far. And a property that assuming it appreciates at just 5% is now worth ~$63K. So by my math that puts me at a cash (/and equity) advantage of about $20-25K just in that 5 years. But that is not the end of the story. That property continues to appreciate, and it continues to pay me rent at about $400/month moving forward. Money I never would have had without this move. Carrying the math out, stopping those payments now, at the 10 year mark this looks like about a $50-60K cash advantage. At 15 years, it is approaching $100K.
I feel like this kind of follows the adage, it takes money to make money. If you put the money to work for you instead of being in your 401K, yet it still ends up working for you at 5% (the rate of the load) because you are paying yourself the interest. The loss of revenue isn’t that bad. Honestly a solid 5% that can be depended on isn’t a terrible comparison to an 8-12% average that has the risk of crashing as well. No were near the potential benefit to having that money to invest it elsewhere. I don’t know though. I almost feel like I have to be missing something here. EVERYONE seems to tell me it’s bad.

Flag |  Dec 07, 2016
kingsley

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Flag |  Feb 13, 2019

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3 votes

The shortest answer to whether or not you should take out a 401(k) loan is as follows:

No. The 401(k) is not the Swiss Army Knife of financial planning. It is not meant to be your cash reserve or your new red truck account. It is meant to be a long-term saving and investing vehicle. The purpose of the retirement plan is to provide for retirement. The double taxation of interest payments, the opportunity cost of being out of the market and the possibility you will get fired or quit are the three main drawbacks mentioned previously. Add to that the idea that a 401(k) loan can also cause your behavior to not reflect a concern for long-term economic stability.

3 Comments   |  Flag   |  Jul 03, 2012 from Austin, TX
H

But what if you are using the loan to buy investment property, to create a long term income plan rather than a new truck? Setting a portion of your 401K to a 5% (loan rate), for the opportunity to buy a rental seems like it could allow you to make more money. I might be missing something though.

Flag |  Dec 07, 2016
Todd Kading, CFP®, ChFC®, RF™

All leverage gives you the possibility to earn more off of investments. That is not unique to using leverage from a k plan. The arguments against using the k plan are those listed in this thread. You are better off using another form of leverage.

Flag |  Dec 07, 2016 near Austin, TX
kingsley

I am a private lender , Do you need a legit, honest, reputable and quick loan? I can help you with 100% guarantee loan, I am offering business and individual loan, More also we financing all kind of projects. For more info contact us today via Email: destinyfirmloan20@gmail.com

Flag |  Feb 13, 2019

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1 vote

Let's also not forget about the tax impact caused when a plan participant with a loan separates from a company - voluntarily or involuntarily. Unless you can pay back the loan within a short period of time after leaving the firm, you'll receive as a parting gift a 1099-R as the loan will be treated as a distribution and added to your income. Add to that the penalty for early distributions on those under age 59 1/2 and you have a really expensive loan option - as well as a nasty kick in the pants when you try to come up with the money to cover the tax bill.

2 Comments   |  Flag   |  May 17, 2012 from Amesbury, MA
H

This is a good point, and the actual real problem I see with doing this. The question for me is if I can depend on being that secure in my job to absorb this risk. Also seems if you have enough wealth you could pay off the remainder of the loan in a pinch, that risk is reduced. But I suppose if that is the case, you really shouldn't need a loan at all maybe. My thought would be to use a loan to buy a rental property. And aside from this problem you state, I really struggle with the concepts of why its a bad idea.

Flag |  Dec 07, 2016
kingsley

I am a private lender , Do you need a legit, honest, reputable and quick loan? I can help you with 100% guarantee loan, I am offering business and individual loan, More also we financing all kind of projects. For more info contact us today via Email: destinyfirmloan20@gmail.com

Flag |  Feb 13, 2019

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