401(k) Loan - Should You Ever Take One? Pros and Cons of Borrowing from 401k Plans

(June 29th, 2009)

You may sometimes find yourself in temporary financial hardship where expenses have sprung up such as a large medical bill, phone bill, college expense, etc and you need to immediately borrow a loan. Your options include credit card, personal loan from the bank or a 401k loan. Afterall, the money in your 401k plan is all yours, so why do you need the permission to borrow? Financial experts however advise to stay away from borrowing 401k loans as much as you can.

In this article, we explore the pros and cons of borrowing from 401k plans and you can then decide for yourself whether it is worth borrowing or not.

Pros of Borrowing from 401(k) Plans

The most distinct advantage of borrowing from 401k plans is that there is no application form to fill out, no credit check, no visit to the bank, etc thus making 401k loans a very easy process. The IRS allows you to borrow a maximum of $50,000 or 50% of your funds, whichever is lesser. The amount you borrow must be paid back in 5 years. Also note that you are allowed to borrow more if you are planning to buy a house and use your 401k funds as down payment. The interest rate charged is the normal bank prime rate + 1-2%. Also note that in 401k loans, you are the lender and the borrower. Thus, the interest payments that you are making are being added to your original 401k balance, thus helping you grow your funds.

Cons of Borrowing from 401(k) Plans

The cons of borrowing from your 401(k) are that once you withdraw money, you are no longer in the tax shelter protection. The interest that you pay yourself on the 401k loan is taxable by the IRS and this eats in to your return. Financial experts think investors who take out 401k loans and pay taxes on the interest payments they make to themselves would be better off investing in stocks, mutual funds or bonds. A major risk of borrowing 401k loans is that if you do borrow a loan and then quit or lose your job, you will have to pay back the entire loan amount within 60 days. If you do not repay the loan in 60 days, you will be charged a 10% penalty on the balance of funds if you are 59 and 1/2 years or lesser. Furthermore, you will have to pay your local state taxes as well as Federal taxes as the loan will be considered a premature 401k withdrawal and not a loan.

Also note that some organizations do not allow you to make 401k contributions while you have a loan outstanding, thus eating in to your long term returns on investment and the total nest egg you will have upon retirement. Also, other companies will automatically deduct 401k loan repayments from your bi-weekly pay check thus making it convenient for your repayments, but not allowing you the flexibility or timing of payments.

Alternatives to a 401(k) Loan

The best alternative to a 401(k) loan is tapping in to your home equity line of credit. If you own a home, your bank can give you $50,000+ cash while keeping your home as collateral, with very low interest rates. In fact, the interest rate offered on a line of credit is less than the interest on a 401k loan. Also, home equity lines of credit offer flexible repayment schedules, talk to your bank about repayment options.