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Author: W401K Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 25265  
Subject: The true cost of a 401(k) Loan Date: 9/25/2004 9:20 PM
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One of the first questions people ask when joining a 401(k) Plan is, How can I get at my money? Well one of the answers is the infamous loan feature. That used, and often abused, feature that lets you borrow money from your retirement plan balance. The trouble with the loan provision is that most people think it has a Visa or MasterCard logo attached to it. Wow, the new Chevy Blazer just came out, I don't have the money for it, I know a 401k loan. It's time for Holiday shopping, I know a 401k loan, or even, its time for vacation, I need to go to the Bahamas to sip martinis on the beach, I know a 401k loan. Its time to retire, why is there no money in my 401k plan...a 401(k) loan!!
Despite the attractiveness of paying yourself interest there are some costs involved in borrowing from your Plan. The first cost to consider is the loss of compounding. If you borrow $10,000 from your Plan, you lose the compounding effect of that money not just for the time it takes you to pay it back, but you are at a disadvantage until retirement. You are basically borrowing money from your future to buy something you may not really need now. I'm not saying to live like a bum now so you can live like a king 20 or 30 years from now, thats an issue for finding a comfortable contribution rate.
When you borrow from a 401k, you must pay the loan back within 5 years. Loans used for purchasing a home can be extended beyond 5 years. These loan re-payments are made via payroll deductions using after tax money. Most people can't afford both loan repayments and salary contributions to the plan, so they lower their contributions or eliminate them all together. This magnifies the problem because not only do you lose the compounding effect of this money, you may also miss employer matching dollars because you can't afford to put in the amount needed to take full advantage of the match.
Another risk is, if you leave your employer before the loan is paid back, it becomes due upon termination. If your employer leaves you.(as was my case) Companies go out of business or may terminate their plan. Either of these events will result in the loan becoming due. (I didn't have a loan) If you have a loan with an unpaid balance and you don't pay it back, you pay taxes plus a 10% penalty on the unpaid balance.
Finally, explore other options. A home Equity loan may be more favorable. Unlike a 401k loan, you can customize the loan repayment period, and the interest paid is tax deductible. True, I'd rather pay myself back the interest on the loan than some mega bank. (or even a minor bank) You pay back the Principal and Interest for a 401k loan with after tax dollars, and you pay taxes again on the money when you withdraw it during retirement. Finally, there are often Loan fees charged by the Plan provider. These can run anywhere from $75-$200 depending on your 401(k) provider.
So, after considering all the costs involved, I would only use a 401k loan in an emergency. After all a 401k /403b is a retirement plan, not a revolving line of credit.
Use it as a last resort escape valve, not as a way to get quick cash.
Hope this is helpful.

Bill

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