Pay your mortgage with 401(k) money? Bad idea!

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Published: Sunday, October 1, 2006 at 6:01 a.m.
Last Modified: Sunday, October 1, 2006 at 12:00 a.m.

Q

I have thought about taking out $50,000 out of my 401(k) to pay off my second mortgage. My thought behind this is that I will be paying myself the interest rather than the bank. I have calculated what the payment would be and can afford this. Why does this sound too good to be true?

A:

Not since my cousin Glenn turned down a job with Microsoft in the '70s to work for a local credit union for $500 more a year have I heard such a bad idea! It does sound too good to be true because it is, especially if you consider losing upward of $100,000 in retirement savings a bad thing.
On the surface, borrowing from your 401(k) seems like a win-win situation: You don't have to qualify for the loan, the interest rate is good (usually prime or just above prime), you are paying interest back to your self rather than to a lender, and by borrowing, rather than taking an early withdrawal, you avoid the 10-percent penalty. Sounds good, huh?
Now, to avoid "Glenn's Folly" (sorry cousin), let's look down the road and see what the future holds. The most damaging disadvantage of borrowing from your retirement plan is the loss in future growth of your retirement fund. Borrowing dramatically affects your bottom line. For example, let's say you borrow $50,000 that you pay back in five years with 7 percent interest. Your 401(k) is earning 10 percent. You are eligible to retire in 20 years. Your fund will be short a net $110,673 at retirement due to the loan. Run the numbers yourself on Bankrate's "Should I borrow from my 401(k) plan" calculator.
If that's not bad enough, let's consider one of life's inevitable curveballs. If your job gets eliminated, your loan then becomes due in full and you are unable to repay the loan, then the loss increases to $431,404 because of taxes and penalties.
Whoa! That $50,000 loan seems a little more costly now, doesn't it? As people are living longer and relying on retirement funds more and more, raiding funds set aside for the golden years becomes less and less wise.
Big disadvantages of borrowing from a 401(k) include:
  • 1. Repayment of the loan is with after-tax dollars, so you will end up paying taxes twice on the same money.
  • 2. On some plans, you might not be able to make contributions with an outstanding loan, which will hurt the bottom line even more.
  • 3. The interest is not tax-deductible.
  • 4. The entire balance of the loan must be repaid in 60 days if you leave your job voluntarily or involuntarily.
  • 5. You are robbing your retirement to pay for today's living expenses.
    With all this said, borrowing from a 401(k) or other retirement account is better than taking an early withdrawal and, in some instances, might make sense if no other options are available and you need money fast. I would, however, recommend you spend time researching all your options and the ramifications before borrowing.
    My advice to you is keep paying off that second mortgage with today's money and leave tomorrow's retirement money alone. You're going to need it.
    Good luck! Steve Bucci is the president of Money Management International Financial Education Foundation and the author of "Credit Repair Kit for Dummies."
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