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The 401(k) Loan: Pros & Cons

By Edited Dec 6, 2016 1 1

There are a number of sources for personal loans these days: retail banks, credit unions, home equity lines, or even an individual such as a friend or family member. Although these are all traditional means to borrow, there is another method that is often overlooked; the 401(k) loan.

If you're contributing to a 401(k) program through your work, chances are you have the ability to borrow against it. Aside from requirements that your employer may impose, such as not being able to borrow in the first place, there are a number of rules the government sets surrounding how you can borrow from your retirement account. Most of these rules are in place to protect the integrity of the retirement system but also to provide flexibility for individuals to borrow from their own future pocket while keeping the borrower honest in the repayment process. Below you'll find some important facts, both pros and cons, that will help you decide if this form of borrowing is right for you.

Pros

No (or Low) Initiation Fee

The good thing about self-borrowing is that there are no or very low costs to begin the process. In a traditional loan, a bank or other lender typically charges something on top of anything before the loan has even begun to accrue interest; similar to points added to a residential mortgage. Whether it is an application fee, initiation fee, or other fee, there shouldn't be any charge of significance when dipping into your 401k before you qualify for normal distributions.

No Credit Check Required

Since you are borrowing this money from yourself, there is no credit check required. This is much different when borrowing from a 3rd party lender in which you need to allow them to check your credit. This is done so the lender understands your financial ability to repay a loan, which can subsequently changes the terms of your loan such as the amount you can borrow and at what rate.

Borrowing Amount & Repayment Method

There is a limit to how much you can borrow and how you pay back the loan. For the amount, it is normally $50,000 or half of your 401(k) balance, the lesser of the two. Some plans allow you to take out additional loans if needed, and to do so, you still have the same restrictions on the amount. The method in which you payback the loan is also very easy as payments are taken out of your paycheck automatically. Paying off the full balance at any point without penalty is an option as well and can be done by contacting the administrator of your plan.

Pay Interest to Yourself, Not a Bank

Like with any loan, during the repayment process you are paying back the principal amount as well as accrued interest. The good news is, when you borrow from yourself rather than a 3rd party, you're paying the additional interest portion of the loan right back into your retirement account. As far as the rate goes, it is typically somewhere near prime and very comparable to what consumer loans normally charge.

Cons

Term of Loan & Termination Restrictions

Unlike traditional consumer loans, there are some restrictions to the length of time you can borrow funds. You must pay back the loan over five years or less unless you borrowed to put the proceeds towards acquiring a home, in which the term can be longer. If within the term of your loan you are no longer employed by your current employer, you must repay the entire outstanding balance within usually 60 days. If you're unable to do so within that time, the loan is then classified as a distribution, which complicates things. You'll now have taxes and other distribution penalties associated with the borrowed amount.

Negative Tax Implications

When you contribute to your 401(k), you do so with pre-tax dollars, before tax hits the gross amount paid by your employer. When you pay back your loan, you do so with post-tax dollars, money that has already been taxed. Although it may not seem like much of an issue, you are losing a considerable amount of income over the term of your loan because Uncle Sam is taking his share.

No Investment Growth & Potential Low Rate

Although it's a great source for borrowing, your retirement account is meant for just that, retirement. During the period in which you borrow from it, those funds are on the sideline and not invested in the market. That means they are potentially not growing with the market at a rate higher than that of which you borrowed. In a bull market, this would be a huge disadvantage, though in a bear market, you will avoid losing your principal while still paying yourself back a fixed rate.

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Comments

Jul 27, 2015 1:12pm
Courtney58
I took a 401K loan once. Due to circumstances beyond my control I wound up with too much debt in credit cards. It was the perfect choice for me at the time. I liked paying myself the interest rather than the bank. But I know it did affect my investment returns. Good article.
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