There’s a trend among 401(k) participants that keeps me up at night. I hesitate to mention it because if you don’t know about it, that’s one less person who’s losing money. Chances are you’ve heard about it, though. It’s the 401(k) loan.
There. I said it. You know about it. Now, let me tell you why it’s such a bad idea.
In theory, taking out money from your 401(k) sounds like a great option. Rather than the hassle of going through a bank, you can take money from your investment account as a short-term loan. The interest you pay on that loan goes back into your investment account, so you’re not really losing any money, right? Wrong. And I can prove it.
Let’s say you take out $25,000 from your 401(k) for a down payment on a house. After all, you’d rather pay interest to yourself than the bank. You have five years to pay off that $25,000 — $5,000 a year plus interest — so you’d pay $425 a month (or more).
What would happen if you left that $25,000 alone for five years instead of using it for the house? Your balance would be $40,000 and change, assuming a 10 percent rate of return. By taking it out, though, you lost $15,000. That’s $15,000 you can never get back because the growth was due to compound interest.
And the story doesn’t end there. You’ll spend the next five years digging yourself out of that hole to get back to your original 401(k) balance — instead of using that time to increase it even more.
Let’s say your original 401(k) balance was $50,000. If you take out that loan, you’ll spend five years getting that 401(k) fund back to its original amount. However, if you spent those years adding $425 a month to that $50,000, you’d be nearing $115,000 in the end. Which balance would you rather have after five years — $50,000 or $115,000? I thought so.
In my years as a financial coach, I’ve talked to thousands of people about their money. The biggest problem I see is debt. Whether it’s student loans, credit cards, or a 401(k) loan (which is debt, people!), being in the red keeps people from reaching their financial goals. And the only way to stem the tide of debt that has flooded our nation is to change the cultural and individual mind-set surrounding finances.
Americans need to understand that a 401(k) loan isn’t the solution to their financial woes. That only puts a person deeper into the quicksand of debt. It’s time that we as a people (and our government) decide to take fiscal responsibility. It’s time that we stop blaming everyone else for our financial struggles, roll up our sleeves, and get to work to change our situation.
What does that mean?
We need a good dose of our grandparents’ approach to money. They lived on less than they earned. They didn’t take out loans every time they wanted to make a large purchase. They saved up the money until they had enough to buy it — whether it was a car or a washing machine. They understood the value of hard work and took on extra jobs when finances got tight. And they definitely didn’t buy things they didn’t need to impress the neighbors. That’s a relatively new phenomenon—and a dangerous mind-set to have.
The total household debt in the United States is roughly $12.8 trillion. Of that, credit card debt accounts for $1 trillion. How can we as a nation expect to prosper if we live beyond our means and hope that someday we’ll magically turn our finances around?
I understand that life happens and some problems cost money to fix. But rather than getting a 401(k) loan to pay for life’s mishaps, why not prepare in advance and put money aside? Then, when Murphy’s Law comes knocking, you already have the money to make it go away. I’d rather be prepared for a crisis than spend time and energy scrambling to fix it.
The 401(k) loan is simply a symptom of a much larger cultural problem. But change has to start somewhere. And one place to draw a line in the sand is by deciding that the 401(k) loan is off the table. It’s not an option. Period. Not only does it keep people in debt, but it also robs them of money they could be earning in their investments if they hadn’t taken out the money in the first place.
And no one comes out ahead in that equation!