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September 29, 2008

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This has been reviewed here before and I have commented before. It still makes no sense to me why this is such a big deal for responsible people.

If I borrow $1000 from a bank and pay them 8% interest after a year I pay them back and I have lost 80 bucks in interest. If my 401k returned exactly 8% and I had 1000 in it then there is 1080 in the 401k after the year. If it earns more or less then I have slightly higher or lower amounts in there but its far from clear what those results would look like. Borrow anything from your 401k in the last 7 years likely resulted in huge savings to your 401k balance.

If however I borrowed the money from the 401k at 8% then after the end of the year I am out the same 80 bucks and my 401k now has the same 1080 in it.

Please explain to me what the big deal is. The only possible answer I can come up with is if you could borrow the money at some cheap rate like 5% and the market returned 20% then you lost the 15%. Which is true but historically the market only averages about 8% anyway. It all seems like a pretty big wash to me.

Yeah, I'm with Apex. I could use a little more clarification on this subject. Withdrawals are definately bad, but borrowing from yourself and then paying yourself back in a short amount of time. I don't get it.

Did you guys click through and read the article?

It's all the same arguments. I have seen them all before. And they are always laid out poorly, and biased. They pointed out the 6% for 6% tradeoff and compared it to the market is up big scenario. They conviently skipped the market is tanking scenario, which recent history including today makes obvious is silly to skip.

Then they talked home equity line. But they skipped a few things. First of all these lines are not free. There are costs over and above the interest. Secondly, they are not always freely given especially in today's environment. I bet half the people reading this, would be turned down. My networth is over a million, and I have been turned down before things were bad when I had 60% equity in my house due to whatever formulas I didn't fit nicely into. And those formulas are much tighter now.

They also said home equity lines are deductable. Thats a broad over simplification. In the most technical sense home equity lines are only deductible if they are used to fund enahncements on your house. They are not deductable for anything else including business startup capital or other things that might make more sense than a loan for a boat. So I would argue that their comparisons are vastly biased and false. Because of this they imply the best case scenario is you only lose your interest. But because most home equity lines do not qualify for deductions you lose your interest in both cases (it also just assumes everyone has home equity that they could even borrow against).

So the one true risk is that you lose your job and have to pay your loan back, and thats a valid point. However if you lose your job and have a big loan out to a bank you are soon going to get behind on that and get your loan called too. You just get 90 days extra before you get hosed. Doesn't seem like its that much safer. Besides some people might have other resources they could use in that situation. I for instance have stock I could sell that I don't want to sell to get start up capital, but if I had to I could. So the losing my job risk is pretty much zero.

This one size fits all zero tolerance approach to 401k borrowing is a bit bothersome to me because the arguments never seem to be presented fully or from both sides. I understand there are countless ways that people can borrow that are stupid. If you want to prevent stupid borrowing then these people should write an article stating that all borrowing is dangerous.

So yeah, I have read the article. Its just like all the others. Except this one is worse because it makes claims that are only true in certain circumstances and leads one to believe they are always true and then skips scenarios that make the argument look weak.

I am just saying, I always hear how terrible this is. I can think of 80 things more terrible that have been going on like crazy the last 10 years. 401k borrowing, when done by a responsible person, pretty close to zero percent terrible.

I notice no one making this argument is every willing to have a debate against the other view or present the other view and show how utterly wrong it is. I mean if this is such a brain dead terrible thing to do, there should be no credible argument which can stand up to even the simplest refutation. Right?

Apex --

Almost all financial principles are "generally" true -- there are always circumstances where otherwise good advice should be ignored. For instance, there are times when annuities and permanent insurance are good deals, times when you could justify spending MORE than you earn, and situations when you should NOT invest now but wait for later. That doesn't mean that the advice is bad, it just means that it doesn't apply in that situation.

So can you find a situation where borrowing from a 401k is a good deal? Of course. (Just like you can find a time where it's ok to buy an annuity, which isn't often.) But is it generally a good idea? No. Why? Because most people don't do it the right way. They borrow as much as they can for as long as they can which kills their return.

Now if they KNOW the stock market is headed down for sure, then of course they can make a better decision. Then again, if they knew that, they'd be a multi-bazillionaire already since they'd know when to invest and when not to. So why borrow if they be so rich?

So it's a general principle. If you're looking for an analysis of every single situation when borrowing against a 401k is good and every situation when it's bad, I don't think one exists -- there are simply too many variables involved. But just like "spend less than you earn" and "buy term and invest the difference" are good moves most of the time, so is "don't borrow from your 401k."

Thats a fair point, but I think it is a bit overstated. I would argue that most of the time borrowing against your 401-k is an even swap to a slight dis-advantage. A few times its a big mistake and a few times its a big advantage.

So I am not actually trying to argue that I can find an exception to the rule. I argue that the rule is an exception. Rarely is a 401k loan a disasterous event. Usually it has little to no impact on long term retirement savings. I argue that the arguments offered to prove the rule actually do not do any such thing. I would be happy to debate those scenarios.

Apex --

I think the difference is that you present a perfect scenario (a person takes good step 1, then good step 2, then good step 3, then good step 4, and all is well.) But what often happens is that something that initially starts out as a decent (or least acceptable) idea, and then "life happens", the plan gets abandoned, or something else. Then the whole thing goes south because the ideal scenario didn't play out.

It's this difference between theory and reality that I think makes a huge difference. I've seen it happen quite often in over 15 years of helping people with their finances. That's why I suggest finding alternative places to borrow (or really, not borrowing at all) as better options.

I'd love to discuss this all day, but unfortunately I have four posts to write for tomorrow, four the next day, and so on. So how about this: you do it your way and I'll do it mine. Then we'll meet in 20 years and see who came out better. Deal?

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