The Loan Ranger: Borrowing From Your 401(k) Plan

I don’t get it. That’s my reaction after reading yet another article about the dangers of taking a loan out of your 401(k) plan. The crux of all of these articles is that you’ll be worse off if you borrow from your 401(k) plan than if you don’t. But what a lot of articles miss is whether you’d be worse off if you borrow from someplace else.

Let’s assume I want to buy a car, and I’m going to have to borrow $25,000 to get it. According to Bankrate.com, interest on a 4-year note would be 6.51 percent. By contrast, many 401(k) plans have interest rates of prime plus 1 percent, which at this writing is 6 percent. So right away, I’m saving ½ percent per year, which makes economic sense to me. Over the life of the loan, I’d save $280, which isn’t a mint, but I’m not going to sneeze at it, either.

Where these articles seem to have a fit, though, is the opportunity cost of withdrawing assets via a loan. They point out that you’re better off leaving your assets invested and getting 7 percent than taking out a loan and getting 6 percent. Well, yeah, I agree that 7 percent is better than 6 percent - if you’re actually getting 7 percent - but how is that any different from putting your account into a fixed income investment rather than an equity investment. As I write this, there are many people who would have loved to have earned 6 percent interest over the past 12 months, and while that’s not always the case, almost every good portfolio model has some degree of fixed income investments. Besides, the difference in that 6 percent and the 7 percent over the term of the loan is pretty small.

Another aspect that these articles bemoan is that the loan taker may stop his contributions, and instead make loan payments. But that’s not an argument against borrowing against my 401(k) plan; it’s an argument against buying a car, period.

To me that’s equivalent to saying I can’t buy a car because I have to save for retirement. If I have only so many discretionary dollars, I may have to decide between a car payment and a 401(k) contribution. I’m not saying participants always make the right choice in this regard, but sometimes it’s a choice that has to be made.

The last bit of warning these articles give is that I would be paying myself back with after tax dollars, and that I’ll be taxed on them again when I withdraw them. Again, the right way to look at that is in comparison with a conventional loan. I would be paying that loan back with after tax dollars (and, as I say above, it would be a higher loan payment, so more after tax dollars would be used). And if I’ve left my 401(k) balanced undisturbed, I’ll be paying taxes on whatever dollars I withdraw, so I haven’t gained or lost any taxability there.

Now, don’t get me wrong, I’m not advocating anyone rush out and take a loan. I don’t particularly like debt, and I personally do what I can to not incur debt. And as an administrator, I’m only moderately in favor of the death penalty for whomever thought it was a good idea to let 401(k) plans have loans in the first place. But don’t let anyone scare you into thinking that it’s a bad economic decision to take out a loan from your plan.

I don’t get it. That’s my reaction after reading yet another article about the dangers of taking a loan out of your 401(k) plan.