Retirement plan decisions made easy
Drill Down: What a 401k Loan Costs You
Borrowing money costs you. You pay interest to borrow money, regardless of where the money comes from. There is a myth out there that it’s free to borrow money from your own 401k because you are borrowing from yourself. That’s completely untrue.
When you borrow money from your 401k, you have to repay the loan with interest. That looks like a cost, doesn’t it? Your 401k account is receiving interest payments from YOU, when it could have been receiving income from someone else. Which do you think is better?
Numerical example:
Suppose that you have $1,000 in a 401k account that is earning ten percent returns. You are thinking about borrowing $400, and your plan requires that you pay ten percent interest.
If you don’t borrow any money from your 401k plan, after one year your plan has increased in value from $1,000 to $1,100. (That’s a ten percent gain on a starting value of $1,000.)
Now suppose that you borrow $400 from your account, paying it back in one year. You have to pay back $440. (That’s the $400 loan plus ten percent interest.) The money that remained in your 401k account, $600, earned ten percent interest. So that money grew to $660. Adding the $440 from the loan brings your 401k account up to $1,100. That’s exactly where it would have been without the loan.
Now what about your personal finances? You borrowed $400, paid back $440 counting interest, so the loan cost you $40. That is ten percent interest.
If you do borrow money from your 401k, you’ll generally have five years to repay the loan, or 15 years if the purpose was to buy your first home. However, your plan may have different rules, so check with your employer before making the decision.
Bill Says: Even though you “paid the interest to yourself” on your 401k loan, you are poorer by the amount of the interest that you paid.
If you have to borrow the money, the 401k may be a good way to borrow it. Just remember that it is not free.
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Lesson 1: What the Heck is a 401k, and What’s So Great About It?
Lesson 2: Contributions to Your 401k
Lesson 3: Investments “Cook Book” Approach
Lesson 4: Investments: How Investments Work
» Lesson 5: Loans and Hardship Withdrawals from Your 401k
Lesson 9: Your 401k, Your Other Assets, and Your Life
The 401k ebook is available in text, audio, and video formats. The current selected format is audio. You may also switch to the text or video formats by clicking on the icons at the top of the main lesson page.