You will at some point in your life require a loan. The need for additional funds will invariably arise, whether it’s for a new home, college tuition, medical expenses, or even the start-up of a new business. The good news is that you have access to a variety of lending options, including those offered by banks, credit unions, credit cards, peer-to-peer lending platforms, family members, and friends.
However, another loan option worth considering is your 401(k) account. Before you commit, you should understand how 401(k) loans operate and the advantages and disadvantages of borrowing from your 401(k), which is precisely what this post will cover.
Identifying if you have a 401(k)-loan option
Your plan administrator can provide information on how to apply if you participate in a 401(k) and your plan provides loans (over 90% of plans do in fact). The majority of employers also permit you to withdraw money from your 401(k) for any purpose, but it’s best to ask your HR department for details on your specific plan.
How much you can borrow from your 401(k)
The maximum loan amount you may obtain is typically $50,000, or 50% of your vested account balance, whichever is less. You may borrow up to $25,000 if your vested balance is $50,000.
Pros of borrowing from a 401(k)
Like any other form of debt, a 401(k) loan has some benefits. These include:
Convenience: Depending on your plan administrator, receiving funds within a few days is frequently as simple as making a quick phone call. Additionally, loan payments are typically taken out of your paycheck, making repayment simple.
No credit reporting: Since there is no underwriting, a credit check is not necessary when applying, and your 401(k) loan won’t show up as debt on your credit report. Additionally, if you miss a payment or default on your loan, it won’t lower your credit score.
Low interest rates: A 401(k) typically offers a rate that is lower than what you can find from other sources, making your payments more manageable.
With a conventional loan, interest is paid back to a financial institution. The interest you pay on a 401(k) loan is reinvested in your account.
Payment flexibility: There are no prepayment penalties and you have five years to repay your loan (or up to ten years if the money is used to buy a primary residence).
If you are a member of the armed forces and are called to active duty, you may be able to suspend your loan payments and/or extend your term.
Cons of borrowing from a 401(k)
On the other hand, taking out a 401(k) loan entails a number of risks. These include:
Missed investment growth: Your money is no longer invested when you take out a 401(k) loan. As a result, you risk missing out on important investment returns, particularly during a bull market.
You may have to repay your loan sooner if you quit your job: Whether you quit your job voluntarily or involuntarily, you may have to do so within 60 days.
Defaulting could result in taxes: If you are unable to pay back your loan, the IRS may tax you for the outstanding balance and impose a 10% penalty if you are under the age of 59 12 years.
You might be turned down: If you are close to retiring, you might be seen as a higher risk and your loan application turned down because payments won’t be deducted from your paycheck automatically. Other reasons for a denial include exceeding your loan limit, having more than one loan open at once, or not meeting the requirements of the plan (i.e. e. , you intend to use the money to pay for your upcoming vacation.
401(k)s from former employers don’t count: You can only borrow money from your current 401(k) plan, unless you rolled over money from prior 401(k)s.
You might contribute less: It’s common for plan participants to reduce their contributions after obtaining a 401(k) loan. Employers may occasionally forbid contributions while participants have an outstanding loan, so you might lose out on employer matching contributions.
As you can see, there are a lot of disadvantages to borrowing from a 401(k), so you’ll frequently read reasons why you should only do so as a last resort.
You should first think about 401(k) loan alternatives before considering your checking, savings, and brokerage accounts.
Sometimes a low-cost solution to meet your cash needs is a home equity loan or line of credit, especially if you require the money to pay for urgent home repairs. Plus, the interest in either solution is often tax-deductible.
Another choice is to apply for a personal loan, which would give you quick access to money and allow you to use it for any kind of personal expense. If you decide to go this route, make sure you compare rates as you would with any loan.
You can use a health savings account (HSA) to pay for qualified out-of-pocket medical costs, such as deductibles and copays. An HSA can be useful if you need money for a legitimate medical expense.
A low or zero-rate credit card could be a good alternative if you can pay off your balance within the promotional period. Depending on the issuer, promotional periods typically last between six and 18 months.
In sum: taking out a 401(k) loan
Consideration of a 401(k) loan should not be made lightly because the risks typically outweigh the advantages. But that doesn’t mean a 401(k) loan is never justified. A 401(k) loan is frequently the best course of action if you’re on track for retirement and don’t anticipate any job changes. Speaking to a CFP® professional is an even better one.
Planning for retirement planning can be complicated and overwhelming. Vision Retirement can help simplify your journey.
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Disclosures: This document is only a summary and is not meant to serve as personalized advice or suggestions for any person or company.
One of the CFP® experts at Vision Retirement did the research and wrote this article.
FAQ
Do 401k loans count as debt?
Since you’re withdrawing your own money, the 401(k) loan isn’t technically a debt, so it has no impact on your debt-to-income ratio or credit score, which are both important factors that lenders take into account.
What is the downside of taking a loan from 401k?
A 401(k) loan has some key disadvantages, however. Although you’ll repay yourself, a significant drawback is that you’re continuing to withdraw funds from your retirement account that are growing tax-free. And the less money you have in your plan, the less money will increase in value over time.