UPDATED: May 17, 2022
People run up against unforeseen financial challenges. The household furnace blew up in the middle of winter, or there’s an unexpected healthcare expense. Losing a job can add financial stress to a household. Whatever the challenge, taking a 401k loan could be a viable option.
If you’re considering this, here’s what you need to know before making a decision.
Reasons to Take a 401k Loan
The biggest difference between a 401k loan and other forms of financing is that you are not borrowing from a bank. You’re borrowing money from yourself, and paying the money back with interest. There are no credit checks to worry about. Neither your payments or defaults go on your credit rating.
On the surface, borrowing from yourself can seem like a good idea. After all, it’s your money. Pay the money back quickly, and there’s a good chance your retirement savings goals will continue to be met.
If you don’t have cash savings outside your 401k, borrowing from your retirement savings is often the least expensive option available. Lenders can charge high interest rates for certain types of loans. Short-term options, like payday loans, can charge 300% or more in interest.
Credit cards charge significant interest, sometimes as high as 23.5% interest. Take a cash advance from those cards, and the interest rate is even higher.
By contrast, the typical rate for a 401k loan is 1-2% higher than the prime rate. This means you’ll pay less interest compared to traditional bank loans.
Another advantage to 401k loans is the speed at which you can get your money. Depending on your employer’s process, the loan can take anywhere from a few days to a couple of weeks to be paid. Admittedly the upper end of this range can be too late, but it’s still faster than the traditional loan underwriting process.
Plus, you aren’t filling out a bunch of forms with income information, and don’t have to pass a credit check. If you have an urgent need for money, this is a good way to get it quickly.
Reasons NOT to Take a 401k Loan
A 401k loan is still a loan. Financial experts agree that taking out loans for frivolous reasons is never a good idea. While borrowing money to go on vacation might sound like fun, you’re potentially impairing your retirement plan. The whole point of a 401k is to have retirement savings stashed away. Pulling money out of your retirement fund can jeopardize your golden years.
Opportunity cost is what you give up by making a decision. You’re forgoing potential investment gains by borrowing the funds from your 401k plan. For example, let’s say your investment gains would have been $50,000 had you left the funds invested instead of taking a loan distribution. The opportunity cost for taking the funds was far greater than the actual amount borrowed.
Some employers won’t let you put any more money in your 401k while you have a loan out. This is a triple whammy: you cannot put more of your own money into it, you lose your 401k match, and miss out on potential investment gains. These are all things that you must consider when calculating the true cost of the loan.
Another pitfall to consider: the consequences of losing your job before the loan is repaid. Traditionally, workers losing or leaving their jobs with a loan balance have had a very short window of opportunity to pay it back. Prior to this year, employees were given 60 days to pay off any principal balance owed. Failure to do so resulted in a loan default, and these carry significant tax penalties. The loan amount is now considered a withdrawal and subject to taxation. Worse, those under 59 ½ have to pay an additional 10% penalty.
Speaking of taxes, your 401k money is originally contributed from pre-tax dollars. However, your loan repayments are done with post-tax dollars. This means it will cost more to pay yourself back than it did to save the money originally.
Lastly, people who take out a 401k loan must have their paychecks reduced by the amount of their payments. While this might be convenient in the short run, it also doesn’t allow for any flexibility. A 401k loan payment has strict terms that make it harder to “modify” or postpone the payment. With money coming directly out of your salary, there’s no real incentive for your employer or 401k administrator to cut you a break.
The Bottom Line
Should you take out a 401k loan?
It depends on your financial situation and need for the money. A 401k loan is an expensive way to get cash and we don’t recommend you take the decision lightly. If it’s for a major medical event that’s out of your hands, that’s an unfortunate, but necessary expense. If it’s for a expensive European cruise, you need to reconsider your financial priorities.
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