• Skip to primary navigation
  • Skip to main content
  • Skip to footer
Proper Cents

Proper Cents

Take Control of Your Finances

  • Guides & Advice
        • Investing & Retirement
          • Complete Guide to Start Investing
          • Complete Guide to Retirement Savings
          • How Much Money Do I Need to Retire?
          • Roth IRA Conversions
          • What is an ETF?
        • Mortgages
          • Complete Guide to Refinancing
          • How to Get Rid of PMI
          • How Much Does it Cost to Refinance?
          • How to Get a Mortgage Pre-Approval
          • What is a HELOC?
          • What is a Cash-Out Refinance?
          • What to Know Before Refinancing
          • Pay Off the Mortgage vs. Invest
          • 15 vs. 30 Year Fixed-Rate Mortgage
        • Loans
          • Complete Guide to Personal Loans
          • Complete Guide to Student Loans
          • How to Refinance Your Student Loans
          • How to Qualify for Student Loan Forgiveness
          • How to Consolidate Debt With a Personal Loan
        • Credit Cards
          • Complete Guide to Credit Cards
          • Credit Card Pitfalls to Avoid
        • Banking
          • Complete Guide to Checking Accounts
          • Complete Guide to Savings Accounts
  • Books to Read
    • Best Behaviorial Finance Book

      The Psychology of Money – Morgan Housel

      This is the one of the greatest money books ever written for novices and pros. Morgan has an amazing ability to take the complicated and make it simple and interesting. It’s a must-read.

    • Best for Long-Term Investors

      The Little Book of Common Sense Investing – John C. Bogle

      John Bogle, the founder of Vanguard, invented index investing. Then he wrote the book on it, literally. This short book explains everything you need to know about getting market returns for the long-term.

    • Best for Getting Out of Debt

      The Total Money Makeover – Dave Ramsey

      Anyone that is drowning in debt and looking to make a major change should pick up a copy of his book. He teaches the Debt Snowball method for paying off your debt as fast as possible.

    • Best for Those Seeking Wealth

      The Millionaire Next Door – Thomas J. Stanley

      Most American millionaires don’t live in mansions or drive expensive cars. This book teaches you the truth about how to build weath, and dispels the myths surrounding today’s millionaires.

  • Recommended Services
6 Steps to Financial Freedom

To Take, Or Not To Take, a 401(k) Loan

September 9, 2020

UPDATED: March 16, 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, borrowing from an active 401(k) is a viable option. 

If you’re considering this, here’s what you need to know before making a decision.

Table of Contents

  • Key Takeaways
  • Reasons to Take a 401(k) Loan
  • Reasons NOT to Take a 401(k) Loan
  • The Bottom Line

Key Takeaways

  • You can borrow from yourself by taking a loan from a current 401k plan
  • A 401k loan doesn’t hurt your credit score, but could derail your retirement planning
  • If you leave your employer, the balance is due within 60 days

Reasons to Take a 401(k) Loan

The biggest difference between a 401(k) 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 401(k), 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 401(k) loan is 1-2% higher than the prime rate. This means you’ll pay less interest compared to traditional bank loans.

Another advantage to 401(k) 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 401(k) 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 401(k) 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 401(k) while you have a loan out. This is a triple whammy: you cannot put more of your own money into it, you lose any employer matching funds, 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 401(k) 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 401(k) 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 401(k) 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 401(k) loan?

It depends on your financial situation and need for the money. A 401(k) 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.

Category iconPersonal Finance

6 Steps to Financial Freedom

From Proper Cents

Calculate Expenses and Find Your Living Cost

Calculate Expenses and Find Your Living Cost (Step 1)

Make a Budget and Track Your Money

Make a Budget and Track Your Money (Step 2)

Consolidate Debt

Consolidate Debt and Streamline Payments (Step 3)

Save a $5000 Emergency Fund

Save a Starter Emergency Fund of $5000 (Step 4)

Automate Retirement and College Savings

Automate Retirement and College Savings (Step 5)

Pay Off Debt and Finish Emergency Fund

Pay Off Debt and Finish Emergency Fund (Step 6)

Reader Interactions

Leave a Reply Cancel reply

Your email address will not be published. Required fields are marked *

Footer

About Proper Cents

Proper Cents is part of the Waaz Media family, and focuses on educating individuals and families about all things related to personal finance.

The mission of Proper Cents is to give a little boost to those looking for a brighter financial future.

Links

Start Here
Blog
About Us
Contact Us
Privacy Policy
Sitemap

Categories

Auto Loans
Banking
Credit Cards
Insurance
Investing
Mortgages
Personal Finance
Personal Loans
Small Business
Student Loans

Join Us on Social

  • Facebook
  • Instagram
  • Twitter

Copyright © 2022 Waaz Media, LLC. All rights reserved.