With millions of people currently unemployed, and high mortgage costs continuing to squeeze, many Americans are turning to their 401k plans to pay their mortgages. But despite the hard economic times, cashing in from your 401k could just make matters worse for homeowners.
According to a study by Watson Wyatt, the number of Americans taking “hardship” loans from their 401k plans rose from 19% to 27%, and that was just in the last few months of 2008. A separate study by T. Rowe Price said that hardship withdrawals increased 25% from September 2007 to September 2008.
Borrowing from a 401k is not difficult. Most 401k plans allow participants to borrow up to 50% of their total plans value and up to a maximum of $50,000. There’s no credit check, since you’re technically borrowing from your own money, and you have five years to pay the borrowed amount back without triggering onerous IRS penalties. In addition, interest rates on the loan are generally only a few points above the prime rate.
However, 401k plan participants who borrow from their 401k’s to pay their mortgage bills should know that in doing so, they may be trading short-term gain for long-term pain.
For starters, once you take money out of your 401k, you’re cutting the legs out from under one of a long-term investor’s best benefits –- compound interest. That’s the amount of accumulated money you earn in a long-term investment like a 401k from year-to-year.
Consider this example. If a 401k investor has $5,000 invested in her retirement plan, and the current interest rate is 10%, the interest rate for the first year of the plan would yield $500 – for a total of $5,500 for the year. Moving forward, assuming the same 10% interest rate for the second year of the plan, now at $5,500, would yield $550 for the second year of the 401k plan – for a total of $6,050 for the two-year period.
But if you borrow money from your 401k plan, you reduce the balance and cut into the potential amount of money in your plan that accumulates interest. Worse, its money that once removed, takes years, if not decades to get back.
Next is the tax issue. Owing the IRS is never pleasant, but the penalties linked to borrowing from your 401k plan are particularly harsh. If you don’t repay the loan within a five-year period, the IRS considers your loan a withdrawal. Immediately, you’ll owe federal and state income taxes on the withdrawal, plus a 10% penalty if you’re under 59-years of age. If you’re laid off, the window really closes. You’ll likely have to repay the entire loan in 60 days as the IRS treats the loan as a taxable distribution.
Pouring even more gasoline on the fire is the fact that you’ll lose out on the value of any company matching proceeds into your plan. After all, you can’t match money that’s not there.
Pointing out the negatives in borrowing from your 401k plan is small comfort to people who need the money to pay their mortgages or other bills. Even so, if you can’t afford a mortgage, other options do include refinancing, applying for a loan modification, or even selling your home. In that respect, you will at least be addressing the problem without potentially ruining your financial future.
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