Having a NO BORROWING policy from your money, or other people’s money, would put you ahead of the game by the time you plan to retire. While this may be true, borrowing money is a personal choice, and if you do borrow money it should be for one or both of the following reasons.
One is that, mathematically speaking, you could significantly improve your cash flow or avoid a financial emergency by taking out a loan. The second reason is that you might relieve yourself of a source of stress, especially if you have explored all other options of overcoming the financial hurdle.
If a loan from your TSP solves one or both of these issues, then perhaps it is a prudent move. Someone online, in a newspaper, or on a late night financial TV/radio show can make all the pronouncements they want about not borrowing, but they don’t have to actually sit at your dining room table and crunch the numbers of your financial life. At the end of the day, you have to feel comfortable interacting with your own money.
Here we will cover the math that goes along with verifying how one’s cash flow and financial standing might be improved by borrowing money from your TSP account.
Loans are typically taken to pay off a debt, such as a credit card, home loan, personal loan, etc. Other times the loan is used to make a necessary purchase or payment, such as covering a medical expense or a home repair.
Is borrowing money from a retirement account detrimental to your long term financial goals, or is it a wise financial maneuver to lower an interest rate or improve cash flow?
Let’s say you have debt on a credit card of $10,000 at an interest rate of 10% (that is a generously low percentage rate). This represents $1,000 of interest due each year, or $83 per month, and you still wouldn’t have touched the principal amount owed. If you decided to pay back that $10,000 over 5 years, your monthly interest and principal payment would be $212.48 per month, or $12,748.80 to borrow $10,000 on your credit card.
An alternative borrowing option is to borrow the $10,000 from your TSP balance. In exchange for doing so, you make a required payment through payroll to replenish the TSP account balance. Be sure to review the TSP’s rules for this as well as consult with your human resources department, and tax advisor before borrowing from your TSP.
Per the TSP’s website, the latest interest rate charged on loans from a TSP is 2.125%, noticeably lower than the 10% or even 20% some credit cards charge.
Using the same 5 year repayment plan, the monthly interest and principal payment would be $175.83. However, this full amount is going from your paycheck into your TSP account. Over the 5 year period, you are paying $10,549 back into your retirement account when you only ‘borrowed’ $10,000 originally.
The difference lies in who you pay the interest to – the credit card company or yourself? The monthly payment due is $36.65 lower than to your credit card or $2,200 total over the 5 years. Plus, when you pay back your TSP, the repayments begin earning interest in your TSP right away.
There is a catch on a TSP loan, or a loan from any kind from a retirement plan that allows it. As soon as you borrow that $10,000, it is no longer earning interest for you in the investment markets. Obviously, if the markets continue their long term increases, and if you left the $10,000 in the TSP, it would earn you more over the 5 years than if you borrowed it and are paying it back incrementally to the TSP over the 5 years.
The trick with the math is not really whether it’s a loan against a retirement fund versus a credit card, or even what the interest rate is. It is what your investment (TSP) portfolio is scheduled to do over the loan repayment term while a portion of the portfolio is not working for you because you borrowed it.
Of course, if we knew in what direction the market was always going to go, life would be much easier. If you don’t think the markets are going to continue their upward run for another 5 years, maybe borrowing from the TSP would actually put you ahead.
As for relieving financial stress, if not borrowing from your TSP means these life altering expenses would end up on a credit card, then you are looking at the math above.
If you do not have a borrowing emergency, try some budgeting resources or consulting with a financial advisor, CPA or other trusted friend to gather some other opinions. One day your future retirement savings will thank you.