Taking a Loan

401(k) loans are very popular.  I have no problem with a participant taking a loan from their 401(k) for a major asset purchase and in some dire emergency situations.  Obviously if you are in a serious financial situation and you can’t borrow money anywhere else, a loan from your 401(k) is something you need to do.  And if you are buying a home, you are purchasing a major asset that will also be a part of your retirement.  When you borrow to purchase a home, you are exchanging a portion of one asset (your 401(k)) for another asset (your home).

Regardless the reason, participants must be aware of all the costs of taking a loan from their 401(k). 

Fees – loans have set up fees and ongoing fees

Lost investment gain – the money you borrow is taken out of your account and the stock market.  When the stock market goes up, the borrowed money doesn’t earn that gain.  The loan has a very low interest rate, and you pay that interest rate.  This is a significant cost on large loans with longer terms. 

Lost savings – if you take a loan you must be careful to avoid the biggest potential cost.  Some participants reduce their contribution deduction so they can afford the loan repayment deduction.  Reducing your contribution will have a negative impact on your 401(k) account.

Bad habit – taking multiple loans over the years increases all of the above costs.  Over time these costs significantly erode your account balance.