Don’t Use 401(k) Loans

It’s a bad deal.

What is a 401(k) loan?

You borrow money from your 401(k). You have to pay the money back in a certain amount of time. It seems like a good idea because you are “borrowing from yourself”, the interest rate is usually “low”, and it doesn’t affect your credit.

What’s the catch?

If you lose or quit your job, you must pay off your loan within 60 days or you will pay income tax and a tax penalty on the remaining balance. Oh, a sweet new job just popped up on the market and you want to apply! Better be able to pay off that loan quick.

Since you sell your investments to fund your loan, you miss out on market gains (or losses, but usually gains). How much does that really cost?

Usually, a lot. As of this writing, 6/20/2017, if you borrowed $20,000 from your 401(k) one year ago, you would have missed out on a 17.66% gain in the S&P500, or $3,532 in lost gains:
s&p1yr

That’s like a credit card interest rate. Sure, maybe the market could have crashed and you would be spared the loss. That’s possible. But that also would probably increase the probability that you get laid off and suddenly need to pay back the loan in full or face the tax consequences.

But that missed $3,532 gets even worse. Now it isn’t compounding for you. Over 20 years, that’s a missed out $14,873 to $42,025.

Paying interest to yourself?

You’re thinking you aren’t really losing that much money. After all, you’re paying yourself back and with interest!

Not really.

If you are able to cover your normal 401(k) contribution plus the 401(k) loan payment, that means you would also be able to be saving more and investing it. That’s why I didn’t go to the trouble of amortizing that example above.

Spending $20k is spending $20k. It is money you would otherwise be able to invest. If you choose not to invest that money, the opportunity cost is your missed returns.

The only exception here is if you used that $20k for a real investment that makes you a real return. Then your loss (or gain) is what your return was vs. what the market would have given you. Did you use that gain to immediately pay back your 401(k) loan? Will it keep earning you a return in perpetuity or is it now sitting around as cash or inventory?

Better choices

It depends on what you are spending on and what accounts you have available.

Margin Loan

If you have a margin trading account at a place like Interactive Brokers, you can borrow against your investments for around 2%, but you don’t sell your investments – they are collateral. Yep, the 2% actually goes to the bank instead of “you”. But since you aren’t selling your investments, which average 7-9% returns, it actually costs you less overall because your investments can still go up, which is the most likely probability. You also have no time constraint for repayment unless you borrow way more than you should and the market crashes and you get a margin call.

So, if you need to float some major expense for a while, such as funding repairs or renovations for a real estate investment, this gives you a lot of flexibility without giving up investment returns.

HELOC

A home equity line of credit lets you borrow against your house at a decent interest rate, often in the 3-6% range these days depending on the terms. The interest is usually tax deductible. Some loans amortize and some are interest-only (lower payment). You don’t give up market returns, but you do have to pay real interest to a bank. It is still better to give up 4% of tax deductible real interest than 8% of market returns.

0% Cash Advance

If you can reasonably pay your loan back within the 0% promo period, a 0% cash advance (with no transaction fee) may also be a good route.

Car Loan

If you’re buying a car and really need a loan for it, just get a traditional low rate car loan if you qualify. Make sure you are getting a good deal.

Spending $20k is spending $20k

Remember that no matter which route you go, if you’re considering these options, you are spending money. None of this money is free. If you are spending on consumption, it will be gone and you will probably have a major opportunity cost. If you are spending this on an investment – a real bona fide investment that earns you real money – this will reduce or beat your opportunity cost.

No matter which way you go, if you can afford the loan payment, that means you can afford to save and invest more. Why don’t you? Hopefully, this money is spent wisely for investment, to cover a true emergency or for something that brings you true happiness.

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