401(K) LOANS - WHAT ARE THEY?

Borrowing money incurs a cost known as loan interest, which is paid to the lender in exchange for the privilege of using the borrowed funds. Consequently, the main purpose of saving and investing is to avoid the need for borrowing altogether and instead have the necessary funds readily available to support future goals.

One distinctive aspect of a 401(k) loan is that, unlike other types of borrowing, the employee essentially borrows from their own account. This means that the borrower's repayments, consisting of principal and interest, are actually returned to themselves (deposited into their own 401(k) plan). In other words, even though the stated 401(k) loan interest rate may be 5%, the borrower essentially pays that 5% interest to themselves, resulting in a net cost of zero. This implies that as long as an individual can afford the ongoing loan payments without defaulting, a 401(k) loan can be considered an "interest-free" loan.

In fact, since the borrower effectively pays interest to themselves, some investors have even contemplated taking out a 401(k) loan as a means to enhance their investment returns. By "paying 401(k) loan interest to themselves" at a rate of 5%, they can potentially surpass the net yield of 2% or 3% offered by bond funds in today's market environment.

However, it's important to note that paying yourself 5% loan interest does not actually generate a 5% return, as the borrower both receives and pays the loan interest. Essentially, paying 401(k) loan interest to oneself merely results in transferring money into the 401(k) plan. Furthermore, unlike a traditional 401(k) contribution, this interest payment is not tax deductible. Additionally, as long as the loan remains outstanding, the borrower forfeits the opportunity to invest and grow the money. Therefore, borrowing from a 401(k) plan to pay oneself interest ultimately leads to missing out on any potential growth.

Consequently, while borrowing from a 401(k) plan may appear enticing for those in need of a loan, the effective borrowing cost is not solely determined by the 401(k) loan interest rate, but also by the "opportunity cost" or growth rate of the funds within the account. Hence, it is not an effective strategy to actually increase investment returns, even if the 401(k) loan interest rate surpasses the returns of the investment account. Instead, for individuals who have "loan interest" to pay themselves, the optimal approach is to contribute the additional funds directly to the 401(k) plan. By doing so, the money can be invested, and the contribution itself may be eligible for 401(k) tax deductions and potential employer matching contributions.

This material was prepared by LPL Financial.

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