By Andrew Comstock, CFA; a financial advisor on NerdWallet’s Ask an Advisor.
Taking out a loan against your 401(k) is often seen as a convenient way to pay off credit card debt, put a down payment on a house or deal with that financial emergency. But borrowing from your retirement savings is usually not a wise financial decision, and data suggest it leads to bad habits down the road.
According to AON Hewitt, a human resources consulting group, one in four participants in a 401(k) plan had taken out a loan against her principal at some time, and some $6 billion in 401(k) loans are defaulted on each year. The trend is sobering, with the amount of outstanding loans rising significantly over the past five years.
On the surface, taking a loan from your 401(k) looks like you are borrowing from yourself. This is true, but it’s more complicated than that. Here’s why taking out a loan against your nest egg is not a wise financial move.
You lose the ability to compound
When you take out a loan from your 401(k) you pay yourself interest but you lose the ability compound your 401(k) assets at higher rates of return. A common interest rate you would pay yourself is the prime rate plus 1%, the sum of which is currently 4.25%. Now compare that to the S&P 500’s average annual return of 8% to 10%, or even the nearly 30% the index returned in 2013. The opportunity cost of losing this level of return is just a killer, and that is missed tax-deferred compounding! Not taking full advantage of compounding could lead to delayed retirement or not having enough saved for retirement.
What if you leave a job or are fired?
If you leave a job or are fired, having an outstanding loan can become a significant headache at a moment when you have more important things on your mind. Some plans offer flexibility on paying back your loan, while others require you to pay it back within 60 days. If you default on the loan, your loan balance becomes a distribution, and if you are younger than 59½ you will owe income taxes on the amount plus a 10% early withdrawal penalty.
It can lead to bad habits down the road
Some individuals look at 401(k) loans as a quick fix to a financial problem or temporarily addressing poor spending habits. Fidelity has done some research on their 401(k) clients, and they found the more loans you take the more likely you are to default and take a hardship withdrawal.
Fidelity found that “half of borrowers take more than one loan, and that the likelihood of taking a hardship withdrawal rises dramatically among multiple borrowers (climbing steadily from 6% for those who have taken one loan to 27% for those who have taken 7 loans).”
In short, 401(k) loans can be a feasible option if you have exhausted all other financial avenues. They should be a last resort, not a means to take a trip to a resort.