The decision to take a loan out against a 401(k) needs to be well thought out. It is tempting to look at the stack of funds sitting there in the company 401(k) plan, and think of it as your own piggy back to borrow against.  It’s very important to remember that these funds are supposed to help support a retirement that could last 30 years or longer. A wrong move can have lasting and devastating consequences. I recently had a client just ask about taking a loan against his plan to fund a down payment of a new home. There are several key points we considered:

Pros

Taking out a loan against your 401(k) is a very simple process and can be done quickly. Most plans offer online access to set-up and process loans.  So in need of quick cash to close the home, this is an easy solution. In addition, if you have bad credit, the interest rate is usually favorable since you are basically paying yourself back.   Of course, this is much better than high interest credit cards or other sources.  Most loans have a 5-year payment term, but for a first-tome home buyer, it is usually 10 years. This can help lower the repayment amount per paycheck.

Cons

This is where we have to discuss human behavior. You have to be very careful when taking out a loan.   If you need a loan, that tells me you might not be saving outside of the 401(k) for the down payment. If this is because money is tight, adding another loan to repay may make things worse. Developing and focusing on a savings strategy might be more appropriate. Also, it is tempting to stop your contributions if you have an outstanding loan, so you will lose on the pre-tax contributions and company match benefits. This is a huge retirement savings opportunity that is gone and lost forever. Finally, if you leave your job you usually have to repay the entire loan quickly which could lead to other bad financial decisions, as well as limiting your career options if you feel you can’t leave your company. If you do leave and the loan is not repaid, the loan is declared a withdraw, and taxes and penalties are due. 

In general, the pros and cons really need to be considered in the decision making process. While a quick fix for needed cash, most of the time we would like to consider other options or strategies instead of a 401(k) loan.

(Research above shows only 20% of all active mutual funds beat their corresponding index over a 10 year time frame.  And of those, only 37% continued over the next 5 years. This is only 205 of 2758 mutual funds that beat their index over a 15 year time frame.  It’s nearly impossible to pick the right ones)

Some investors select mutual funds based on past returns. However, funds that have outperformed in the past do not always persist as winners. The most important guideline to remember is: If a fund does not fit into your overall investment strategy, it’s a dangerous choice no matter how it’s performed in the recent past.

Investors have a tendency to weight recent events more heavily than history. It’s nearly impossible for the typical investor to choose a fund that had negative returns in the previous year. Yet that fund, historically, may have proven to be an outperformer in its category. And the largest hurdle is that most investors don’t even think they are chasing performance. Research shows, however, that nearly every mutual fund outperforms individual investors in the fund.

Instead of chasing performance, investors should follow on these 4 rules:

1. Develop an investment strategy and COMMIT to it

Every investor should have a disciplined investing strategy and stick to it, through bull and bear markets. A relationship with a professional financial advisor is the first step to developing this strategy, and it insures that you’ll take the right actions at the right time.

2. Rebalance your portfolio

Rebalancing your portfolio will keep you from buying high and selling low.  Investors who chase returns, are adding to a piece of the investment pie that’s already too big. If you rebalance your portfolio once a year, you’ll be insured that you’re adding to the smaller piece of the pie, and inherently buying low and selling high.

3.  Remain Invested

Don’t be tempted to pull your investments from the market when it falls. These are the most opportune times to increase long-term returns through rebalancing.

4. Focus on your personal goals

Your personal goals should drive your investing strategy. Keep that in the front of your mind and it will be much easier to remain disciplined.

Remember, past performance alone provides little insight into a fund’s ability to outperform in the future. A more disciplined approach has proven to be the best way to increase-long term performance.

Recently, a Park + Elm client asked for some advice on handling his finances now that he is a new business owner. Small business owners are in a unique financial position, so we created a 5 step process to follow during your ownership years. Many self-employed investors won’t have the same range of assets that a life-long employee would have at retirement, so planning for your eventual exit from the business is also crucial.