Borrowing against a 401k is one of those things that no one wants to do but simply may be unavoidable for one reason or another. An emergency situation could force you to borrow from your retirement to meet your liquidity needs. But if you are considering borrowing against your 401k plan, please be aware of the advantages and disadvantages of that choice.
Pros of Borrowing against a 401k
The biggest advantage of a 401k loan is that it is a whole lot easier than borrowing money from a bank. Since you are borrowing your own money, you do not have to fill out a credit application. Unlike with a bank loan, you can get the loan from your own 401k with bad or poor credit with no problem. You just typically need to contact your 401k plan provider and request a loan.
Since you are borrowing your own cash, your interest rate will be a lot lower than with unsecured loans that you would get from a bank. This will make it a whole lot easier to pay off your loan at a faster rate.
Another advantage is that your interest payments are not lost. Interest payments that you make towards a bank loan go into their account. Interest payments that you make on your 401k loan go back into your 401k account. You can make money off of yourself for repaying your loan.
Cons of Borrowing against a 401k
One of the biggest disadvantages is that the money that you withdraw will no longer be making you money. You will lose interest on that principal while it is withdrawn.
Also, you are not allowed to make any more contributions into your account until you repay the loan with most 401k plans. That means no more matching employer contributions either. You are losing out on a bunch of free money until your account is paid back.
Finally, borrowing against your 401k means that your repayment period will be a whole lot shorter than a traditional loan. Your loan period could be just a few years, which means that your monthly payment will be higher in order to pay the loan back faster. If you leave the company, you could also have to repay the loan in a relatively short period of time. This would be placing an additional strain on your finances.
If you ultimately fail to repay the loan, it is considered an early withdrawal and you have to suffer all of the normal consequences like a 10% early withdrawal penalty or the borrowed amount throwing you into a higher tax bracket overall for the year.
My Personal Take on 401k Loans
All in all, if you just have to get a loan from somewhere, a 401k loan isn’t an awful option, BUT I wouldn’t do it unless it was a straight-out emergency. I would use up our actual emergency fund, cash in stock investments, and probably look into a Home Equity Line of Credit (HELOC) before I’d touch my 401k or Roth IRA. The biggest reason is that I wouldn’t want to lose out on the company match while I had the loan. I am not paid enough as it is, so I am definitely wary of giving up one of the best benefits I have even for just a little while.
How about you? What circumstances would have to occur before you’d take out a 401k loan?
Crystal Stemberger uses Budgeting in the Fun Stuff to write about finding the balance between paying your bills, saving for your future, and budgeting in the fun stuff along the way.