Pros and Cons of 401k Loans
- March 20, 2017
- By: Greenpath Financial Wellness
If you are in need of cash, you may consider taking out a 401(k) loan. With a 401k loan, you are basically lending money to yourself.
You can typically take out up to 50 percent of your retirement funds or $50,000, whichever is less. Your employer sets the terms of a 401(k) loan, which must be repaid within five years unless you are using the loan to purchase your primary residence. In that case, it typically must be repaid within 10-15 years. Your payments on the loan are taken out of payroll AFTER taxes.
Why a 401(k) Loan May NOT Be Advisable
- If you lose your job, you must pay off the loan within 60 days. Otherwise, unless you are at least 59 ½ years old, you will pay penalties (typically 10%) and additional taxes (defaulted loan amounts are treated like an early retirement withdrawal). So think twice about going this route if your employment status is unstable.
- Taking money out of your retirement account will make your retirement money grow more slowly. The money is taken out of your investment accounts and then added back in as you pay it back.
- A 401(k) loan will not help you if you are already living paycheck to paycheck because your take-home pay will actually decrease.
- Some 401(k) loans have provisions where you cannot add to your 401(k) while paying on a loan, so this stops you from adding to your retirement.
- When your investments go up, you miss out on gains because you have taken money out of your investments and can’t contribute to new investments. Bankrate.com has a 401(k) loan calculator that can show you how much money you can lose by choosing this option. If your company matches contributions to your retirement, you would be missing out on that money too.
- Taking out a 401(k) loan could suggest that you are living beyond your means. Taking money out of retirement savings should only be a last resort. Talk to a credit counselor to get some free advice on your options prior to making this decision.
Why a 401(k) Loan May Be Worth Considering
- The interest you pay on a 401(k) loan is paid to yourself.
- It’s easy to get a 401(k) loan. There are no credit checks. A 401(k) loan can be used for an emergency if you have damaged credit or no credit that makes it difficult to get a traditional loan such as a personal loan or home equity loan.
- 401(k) loans can have a low interest rate. It’s usually prime plus 1 to 2 percentage points. The prime rate changes daily, but over the past few years it has hovered around 3.25% which would give you an APR of 5.25%.
- You can usually pay back a 401(k) loan early with no repayment penalty.
- It can be a decent loan to get for the short term — one year or less.