Net Gains: Why You Shouldn't Take a 401(k) Loan

Feb. 27, 2008 — -- Thirteen years ago, my wife and I borrowed $3,500 from our 401(k) plans to help cover a down payment for our home.

It was one of the dumbest financial moves we ever made. By one calculation, it may have cost us about $18,000 in future retirement savings.

We would have been better off adding the $3,500 to the mortgage balance rather than tap retirement savings. At most, that would have cost us an extra $7,300 in interest payments. In reality, it probably would have been less given the mortgage-interest tax deduction and later refinancing opportunities.

Like many 401(k) borrowers, I rationalized my decision. I told myself we would be paying interest to ourselves. What I didn't realize at the time was we stripped away the tax advantages of a 401(k) account and the power of compounding.

The result? We had to come up with an extra 25 cents for every dollar we borrowed just to pay down the principal, never mind the interest. Even more painful was the lost compounding potential of our original $3,500 investment.

I bring this up now not because I dwell over financial regrets. Other moves I made turned out to be better decisions that more than made up for the dumb ones.

Still, I offer my own 401(k) borrowing experience as a warning to those who think a loan from their retirement savings plan is a smart financial move when cash is tight.

I know these are tough economic times for many families, so I won't lecture those facing true hardship. But I urge them and anyone else thinking about taking out a 401(k) loan to do so only as an absolute last resort.

Consider every other alternative first. In some cases, borrowing against home equity may be a better long-term move. That, of course, assumes you have available home equity to tap in a falling real estate market.

A sizable withdrawal from retirement savings -- even if you pay the money back -- can mean a substantial setback to financial security in your later years when you may have even fewer options. And if you are unable to repay the loan, your retirement will take an even harder hit.