Your 401k is for your retirement, you know, the time where you no longer work and need capital to support your life. By borrowing from your 401K, you are robbing your future self in the hopes of having a better life now. This is completely backwards thinking. Instead, you should be squirreling away your income now so that you can live a more comfortable life when you are less able.
Who is going to take care of you when you are old? The government? Doubtful. Your kids? Hahaha! Only you can rely on yourself. If all my wealth disappears now at age 35, I have the energy to find a new job, work on a new idea, and survive. If I have nothing at the age of 70, I’m screwed and will become a burden on society, thank you very much.
So many people who borrow or want to borrow from their 401K think they are smarter than they are. They argue that they’ve either found a better investment, or they just absolutely need to have that new car or house. This inability to delay gratification is one of the main reasons why we got into this economic mess in the first place!
Unless you have some serious type of life-threatening emergency and for some reason don’t have any savings, do not borrow from the 401K. Treat your 401K like a sacred hippopotamus. Let’s talk about various reasons why some borrow from their 401K.
MAIN REASONS WHY PEOPLE BORROW FROM THEIR 401K
“I’m good enough, I’m smart enough, and dog-gone it, people like me.” – Stuart Smalley, SNL
* To pay for medical emergencies. Hopefully with Obamacare, fewer people will get financially slaughtered due to unforeseen medical emergencies. Using your 401K to pay for medical emergencies is not a bad idea, provided that such expenses have high interest rates and could damage your credit if not paid.
* To buy a car. This could be the dumbest thing ever. If you cannot afford a car, do not buy a car. In the land of Internet and fantastic public transportation, if you are spending much more than 20% of your gross income on your car, you cannot afford it! Furthermore, if you do not have enough disposable cash lying around to pay in full, you likely can’t afford your car either. Considering spending the least amount of money on a depreciating asset.
* To buy a house. I’m not sure when we got this notion that we all deserve to be homeowners, but it is really wreaking havoc on people’s finances. If you cannot afford to put at least 20% down on your own and have another 10% buffer in cash, you probably do not deserve to buy a house. You are putting your neighbors and the entire economy at risk for buying an enormously expensive asset you can’t afford. If you default and go into a short-sale, you will immediately drag down the value of your neighbors even though they’ve always paid on time. There will always be houses for sale. Wait until you’ve got the capital.
* To invest. Although there are plenty of good enough options to invest within your 401K, some people can’t resist investing in the next good idea. The large majority of private equity/angel investments go nowhere. The large majority of great ideas that seem too good to be true, or exactly that. Unless you are a sophisticated investor with a fantastic investment track record, do not borrow from your 401K to invest in other things you don’t fully understand. Trust me, you are not Warren Buffett.
* To keep up with the Joneses. This is really one of the worst things you can do. Because your 27 year old friends own houses, even if you don’t have the capital, you are propelled to own a house yourself to keep up. You tell yourself that because you studied hard in school, are smart, think you’re good looking, and make $80,000 a year you deserve all the good things as someone older than you. Here’s how I deal with money envy.
MAIN NEGATIVES OF BORROWING FROM YOUR 401K
* Teaches impatience. I firmly believe that doing anything successfully takes methodical planning and patience. Whether it’s starting a business, playing a sport, thriving in your career, or saving a nice nut for retirement, you need to have the fortitude to push on through when things don’t look so great. If you look at the chart below, those with $5,000-$9,900 have a much higher propensity to borrow from their 401Ks than every other account balance segment. It’s as if as soon as there’s a decent chunk of change, this segment feels a need to raid their account for something.
* Gives you a false sense of security. Don’t let your 401K be a crutch on your wealth building endeavors. If you always carry the mindset that you can borrow from your 401K, you might not try as hard to build income streams that are in your control. It’s easy to get lazy when we have a crutch. Big government allows us to not try as hard. Unions allow us to not fight as hard. The Federal Reserve allows us to not spend as carefully. Beware of moral hazard.
* Could create a double whammy. If you need to borrow money from your 401K, chances are you don’t have as much money in liquid savings to feel financially comfortable. If you end up losing your job, your 401K loan comes due immediately. If you so happen to spend your 401K to borrow more money (like get a mortgage), you are going to experience a world of financial hurt.
* Decreases your chances of wealth maximization. After creating a game plan for financial security, we must then hope for the best. The more we save and the more we do our research, chances are the more financial security we have. Being old and poor is no way to live. How many times have you heard 55 year old people in the news say they are devastated after a layoff? How can you be devastated if you’ve had 30 years to save and invest? Life happens all the time. Don’t expose your golden hippo to the chicaneries of life. The money in your 401K and IRA are protected in bankruptcy.
Source: Vanguard April 2012 Report by Cynthia Pagliaro
GIVE YOUR 401K TIME TO MARINATE
Your 401K balance adds up over time. After 10 years of maxing out your contributions, your 401K will likely grow to over $200,000. You don’t have to be a genius investor at all. Company matches and compounded returns do the work for you! After 30 years of maximum contribution, there’s a great chance you’ll have more than $1 million dollars in your 401K alone!
Financial Samurai 401K Progress Guide
If you raid your 401K because you think you deserve something before you should, you will put a stop to compounding, momentum, and wealth accumulation. I can promise you very few people who borrow from their 401K will be able to follow my 401K progress guide. If you have a 401K, treasure it by preserving it.
Be patient and wait your turn. Tell yourself you are nobody special, to prevent yourself from financial misfortune. You’ll be happier, and so will the rest of the economy!
Recommended Actions For Building Wealth
* Manage Your Finances In One Place: Get a handle on your finances by signing up with Personal Capital. They are a free online platform which aggregates all your financial accounts in one place so you can see where you can optimize. Before Personal Capital, I had to log into eight different systems to track 25+ difference accounts (brokerage, multiple banks, 401K, etc) to manage my finances. Now, I can just log into Personal Capital to see how my stock accounts are doing, where my spending is going every month, and how my net worth is progressing. Personal Capital is great for tracking your 401K balance and reducing portfolio fees. There is no better free online platform that has helped me grow my 401K to over $400,000 and outperform the market. It only takes a minute to sign up.
* Peer-to-Peer Lending As An Alternative: If you absolutely must borrow money, consider borrowing via peer-to-peer lending instead of your 401K for all the reasons we’ve discussed. Rates start as low as 6.59% and you can borrow up to $25,000 if you qualify for a variety of things including: consolidating your debt, medical, adoption, home improvement and more. Just make sure you borrow responsibility, and preferably for wealth increasing purposes. Prosper.com is based in my hometown of San Francisco and they are regulated by the SEC. You can borrow with Prosper.com here.
About the Author: Sam began investing his own money ever since he first opened a Charles Schwab brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college on Wall Street. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. He also became Series 7 and Series 63 registered. In 2012, Sam was able to retire at the age of 35 largely due to his investments that now generate over six figures a year in passive income. Sam now spends his time playing tennis, spending time with family, and writing online to help others achieve financial freedom.
Updated on 2/10/2015