You know the expression about something being too good to be true? That’s the case when it comes to borrowing from your 401(k). This might seem like a good idea when it comes to making a large purchase or paying off debt, but there are consequences. You are not just borrowing from yourself. Because of the effects of compound interest, you’re actually borrowing from your future self, and robbing yourself of the blissful retirement you deserve. And why would you want to do that?
If you are thinking of borrowing from your 401(k), here are some important things to consider first.
You’re Missing Out on Money
Interest rates on 401(k) loans can be very appealing. You have the ability to borrow your own money and pay interest to yourself rather than a bank. Seems like a good deal, right? But not only are you missing out on the effects of compound interest, but the market may end up making money.
What this means is when you take out a loan you’re actually selling your assets. Then, when you go to repay your loan, you may end up buying shares in a fund at a higher price.
It is also important to note that if you’re unable to repay your loan within the time frame allowed, your loan will be considered an early withdrawal. This mean you will pay a 10% penalty if you are under the age of 59 ½ and have to pay extra income tax.
You Get Taxed Twice
For a traditional 401(k) plan, you make contributions with pre-taxed dollars. You won’t actually pay any taxes until you withdraw from your account as income during retirement. However, by borrowing from your fund, you will effectively be taxed twice. This is because you’d be paying back the loan with after-tax dollars. Then, when you wish to withdraw during retirement, you will be taxed again.
You Can’t Make Contributions Until the Loan is Repaid
Typically, most 401(k) plans will not let you continue to contribute money until you have repaid the full amount you have borrowed. Since this could take years, this means missing out on years of potential contributions (and the effects of compounding interest). You will miss out on the growth and interest you would have accumulated had you just left your money where it was.
It Could Be Risky
If for some reason you stop working or are let go by your employer, you may be required to repay the loan in full within 60 days. If you cannot meet the payment obligation, your loan will be considered an early withdrawal and you’ll have to pay the 10% penalty as well as income taxes! Talk about a big blow to your bank account!
You’re Stealing from Yourself to Pay Someone Else
By using your 401(k) to pay off debt, you are essentially just moving your debt around, as you will still have a loan that needs repaying. Some see this as a better option than paying a bank because interest rates are lower. However, even if you pay your loan back on time, you will have lost out on maximizing the effects of compounding interest. You are really just robbing from your future self.
Now you can see why taking a loan on your 401(k) may not actually be a great idea. While it may seem like an easy way to access immediate funds, you’re only hurting yourself. Instead, make a plan to save for a big purchase or develop a debt repayment plan that doesn’t involve needing to dip into your 401(k). With proper planning and a little patience, there are usually ways to reach your goals without compromising your future.
It isn't always easy to stay on top of your finances, especially when you have developed unhealthy spending habits over the years. However, as you begin to realize the many benefits of having healthy finances, it can become something you want to make a conscious effort to improve. When your finances are in a good place, you often have access to better opportunities whether it be a mortgage loan, greater credit line or business loan. On that note, here is how you can become an expert at managing your finances in case you need a few tips.
Learn to Use Technology
The good thing about managing finances in the technological age is that you don't have to do it alone. There are so many apps available that will help you pay bills on time and track your expenses. For instance, some apps force you to live within your actual income and tell you what to do when you need to balance your budget.
If you need an app that will help you get better at saving, then some will set aside your spare change for you. Also, don't be afraid to use more simple tools such as your smartphone calendar to set reminders about payments if you don't automate them.
Seek Legal Advice
Sometimes, being an expert at something means understanding that you can't possibly know it all. This is why you have professionals around you that can help fill in the gaps where you're lacking. Consider hiring a legal firm to help with any challenges that are beyond you. Lexington Law is a good firm as they could help remove negative items from your credit report. Read this Lexington Law Review (Our #1 Credit Repair Service of 2019) to find out more about how they could help improve your finances.
You can't do better than what you know when it comes to managing finances. You should, therefore, invest your time in learning more about finances and how to manage them. Think about what your goals for your finances are and what knowledge gaps you need to fill.
For example, if you want to invest in the stock market so that you can improve your net worth, then you may need to learn more about investing to do so successfully. To boost your knowledge, try reading articles on credible blogs that share finance information from professionals. Also, be weary of content from finance-driven companies as it could be biased.
Work on Growing Your Income
As a self-proclaimed finance guru, you know that the more sources of income that you have, the better. Work on increasing your streams of income so that you have more money to meet your targets whether it's to save for a property or put larger sums towards retirement. One way to do so would be by getting extra income by doing social media marketing for businesses or creating tutorials on YouTube. If you own a property, renting out rooms is a great way to make passive income.
Live Within Your Means
It can be difficult to live within your means when you live in a society that is always presenting you with things to buy. However, being more conscious about the things that you purchase could help you realize that most are wants rather than needs. To live within your means, always take time to think about a purchase as opposed to impulse spending. You should always get good at bargain hunting as many times you can find items of similar quality at a cheaper price.
Learn How to Manage Debt
Debt doesn't have to be a bad thing if you understand how it works and how to manage it. It can be a tool for credit building when you understand the fundamentals. For instance, if you take out a loan or credit card, always be mindful of your interest rates.
By paying the amount of money you borrowed back in full before the due date, you won't have to pay interest on what you borrowed. If you can't pay back in full, paying more than the minimum payment will ensure you incur less interest. For the most part, the secret to good debt management is never spending more than you can afford to pay back.
Managing finances is a life skill that can help improve your quality of life. By following the mentioned tips and taking your finances more seriously, you're more likely to master the art of healthy finances.