Borrowing money has a cost, in the form of loan interest, which is paid to the lender for the right and opportunity to use the borrowed funds. As a result, the whole point of saving and investing is to avoid the need to borrow, and instead actually have the money that’s needed to fund future goals.
A unique feature of a 401(k) loan, though, is that unlike other types of borrowing from a lender, the employee literally borrows their own money out of their own account, such that the borrower’s 401(k) loan repayments of principal and interest really do get paid right back to themselves (into their own 401(k) plan). In other words, even though the stated 401(k) loan interest rate might be 5%, the borrower pays the 5% to themselves, for a net cost of zero! Which means as long as someone can afford the cash flows to make the ongoing 401(k) loan payments without defaulting, a 401(k) loan is effectively a form of “interest-free” loan.
In fact, since the borrower really just pays interest to themselves, some investors have even considered taking out a 401(k) loan as a way to increase their investment returns, by “paying 401(k) loan interest to themselves” at 5% instead of just owning a bond fund that might only have a net yield of 2% or 3% in today’s environment.
The caveat, though, is that paying yourself 5% loan interest doesn’t actually generate a 5% return, because the borrower that receives the loan interest is also the one paying the loan interest. Which means paying 401(k) loan interest to yourself is really nothing more than a way to transfer money into your 401(k) plan. Except unlike a traditional 401(k) contribution, it’s not even tax deductible! And as long as the loan is in place, the borrower loses the ability to actually invest and grow the money… which means borrowing from a 401(k) plan to pay yourself interest really just results in losing out on any growth whatsoever!
The end result is that while borrowing from a 401(k) plan may be an appealing option for those who need to borrow – where the effective borrowing cost is not the 401(k) loan interest rate but the “opportunity cost” or growth rate of the money inside the account – it’s still not an effective means to actually increase your returns, even if the 401(k) loan interest rate is higher than the returns of the investment account. Instead, for those who have “loan interest” to pay to themselves, the best strategy is simply to contribute the extra money to the 401(k) plan directly, where it can both be invested, and receive the 401(k) tax deduction (and potential employer matching!) on the contribution itself!