So you need a loan. Is there any good reason not to borrow from your 401(k) account? After all, you’re really borrowing from yourself, right? But you could also say that you’re borrowing against your future financial security. Know the pros and cons before you borrow.
If you are in need of a loan, your 401(k) certainly may be an option. But it’s important to understand a bit about them before making your final financing decision.
401(k) loan characteristics
- Generally, you cannot take a loan for more than $50,000 (which could be less depending on your plan balance or if you had recently taken a prior plan loan)
- Maximum repayment term is 5 years (up to 25 years if used to purchase a “main home”)
- Your credit history doesn’t impact your interest rate
- All loans are fully amortized immediately (i.e., both interest and principle are paid)
- Likely requires spousal “sign-off” to acquire
Advantages and potential risks
Advantages
- Easy to obtain—no underwriting, as typical with a conventional loan
- Pay yourself back—in repaying the loan, you pay your 401(k) back instead of another lender
Potential risks
- “Opportunity cost”—when you borrow from your 401(k) account, you’re usually removing an otherwise invested portion of the balance. (And while returns are never guaranteed, you are taking invested monies out of an account that could be growing.) On the flip side, taking the loan out before unpredictable market downturns hit could be temporarily beneficial
- Job Loss—your company’s plan may require an immediate payment in full at termination of employment. The balance becomes a distribution. Depending on your age and circumstances, this distribution might result in income tax and possibly a 10% additional tax
Note: It is possible to roll this amount into an IRA to avoid taxation. A 2018 tax law change now allows that rollover to occur by the plan participant’s tax filing deadline, including extensions.
Other loan choices
Tapping your 401(k) is likely not your only financing option. Here are some others:
- Home equity loan or line of credit—here you may also get a tax deduction, but your home is at risk should you default
- Margin loan against the value of certain securities held in a brokerage account—fairly easy to obtain, but a risk that should securities drop in value, the sale of securities could be required to meet margin requirements
- Personal loan or credit card
Weigh your options
It can be hard to figure out which type of loan makes the most sense. Of course, loans outside of a 401(k) might provide greater variety—different repayment periods, interest-only periods, fixed vs. variable rates, etc. And we’ve discussed the advantages and potential risks above.
Important considerations
Loan-related fees can be substantial, and you’ll want to carefully compare all your options.
When the outside loan rate is below the assumed 401(k) rate of return, the lean is toward going with the “cheaper” outside loan. When the outside finance rates rise above that assumed investment rate of return, the tide shifts to the 401(k) loan, which would then be less costly.
The one big X factor that we mentioned earlier needs to be emphasized again here—returns are not guaranteed; and the more aggressively you are invested, the less guaranteed it becomes, particularly over something like the five-year period.
As you can see, determining whether to go with a 401(k) loan or conventional loan requires some research and planning. Reviewing the decision with a financial advisor may help you make the decision that’s ultimately right for you.
