Deciding to borrow from your 401(k) is a decision that shouldn’t be taken lightly. Before moving forward you should understand the full picture of what happens when you do and what your potential risks are going to be. One major aspect of borrowing from your retirement is the topic of where the interest goes. That interest technically goes back to your account, but that might not be reason enough to move forward with a loan. You may want to work with a financial advisor to fully investigate the gravity of your situation.
Understanding Interest on a 401(k) Loan
Taking a loan from your 401(k) account may seem simple at the onset, but there’s a bit more beneath the surface. In particular, you need to grasp how the interest on such a loan is calculated and where it ends up. For instance, if you take out a $10,000 loan from his 401(k), where would the interest on his loan go? Let’s take a closer look at both how that interest gets calculated and where it goes.
How Interest Is Calculated
Remember, when you borrow from your 401(k), you’re borrowing from yourself. It’s your money in that account that you’re taking out, but it’s your money that is already earmarked for your golden years. The interest is calculated based on the loan amount and the rate over the specified duration of the repayment period.
Since it involves multiple variables, it’s advisable to consult with a financial advisor who can provide personalized calculations to help you understand the implications better. For example, a loan amount of $10,000 from your 401(k) at an interest rate of 5% would result in a total repayment of $10,500.
However, the current interest rate you’ll pay on your 401(k) loan is typically 1-2 points higher than the prime rate. At the time of writing the prime rate is 8.5%, meaning you’ll pay 9.5% – 10.5% on the money that you borrow. So that $10,000 that you borrow could cost you more than $1,000 of total interest.
Where the Interest Goes
While it’s somewhat comforting knowing that the interest paid on the loan technically goes back into your account, it’s not quite that simple. Plainly put, interest paid on such a loan gets taxed twice – first when you pay it and then again when you withdraw it during retirement. Plus, there can be consequences for not paying the money back on the scheduled timetable.
Risk of Taking Out a 401(k) Loan
While borrowing from your 401(k) may seem like an appealing financial strategy, it does come with its own set of risks that surround the idea of not being able to repay the loan. For example, if you can’t repay the loan, it’s considered a withdrawal, which results in potentially owing taxes and penalties on top of what you’ve already paid back.
Not repaying your loan in a timely manner not only can put you in a worse financial position in the short-term, but you’ve also taken money out of your account that is no longer growing. This means that you’ll have less money for retirement. Even if you repay the funds, the amount of money you borrowed wasn’t growing during the time period you were repaying that money. That is a loss that you can’t ever recuperate.
Why Paying Interest to Yourself Is a Bad Investment
While paying interest to yourself may seem beneficial, because you’re paying the money back into an account you own, there are negative ramifications. The borrowed money loses the potential benefit of compound interest—a crucial element of long-term investment growth.
For example, a loan of $10,000 that isn’t repaid could mean forgoing $16,386 of growth over 20 years if assuming a 7% annual return rate. That’s a significant loss just from needing a short-term shot in the arm financially. It’s typically better to find another way to get the money since you’ll likely end up losing more money than you’re gaining. Keep in mind, though, that this is a very personalized investment decision that is unique to you.
Reasons You May Want to Borrow From Your 401(k)
Despite potential risks and losses, there may be situations where borrowing from your 401(k) seems necessary. This is when it becomes important to weigh the pros and cons, including the risks, before making such a decision. Doing so can help you find the right solution for you. Here are some situations where it might make sense to borrow from your 401(k) account:
- Repaying high-interest debt
- Making a down payment for a home
- Covering the costs of an unexpected emergency
- To save your home from foreclosure
- To protect other more valuable assets
However, these decisions ought not to be taken lightly or be made without the help of a professional. It is advisable to consult with a financial advisor who can guide you in assessing the long-term financial implications tailored for your situation.
The interest from your 401(k) loan goes back into your own account but it may not be worth it because choosing to borrow from your 401(k) comes with both immediate implications and long-term consequences. It should be seen as one of the many financial strategies available to you, rather than solely a decision of last resort. By familiarizing yourself with the nuances of 401(k) loan interest and seeking professional advice from a financial advisor, you can make a more informed decision that best aligns with your financial journey.
Tips for Managing Investments
- Deciding to take out a loan on your retirement assets can be a huge decision that has many layers to it. Without the right experience, you may not be able to consider all angles of making that decision. That’s where a financial advisor comes in, who can help you make the right financial decisions in order to reach your long-term goals. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you want to better understand your risk profile for your own portfolio and what types of investments might be right for you, consider using an asset allocation calculator.
Photo credit: ©iStock.com/blackCAT, ©iStock.com/ftwitty, ©iStock.com/nicoletaionescu