When is Borrowing From Your 401(k) a Good Idea?

June 20, 2014

If you ask most financial planners when is the best time to borrow money from your 401(k), the overwhelming answer will be “NEVER”! And, for the most part, I agree with that. But, like almost every rule, there are exceptions.

This article talks about all of the reasons it’s a bad idea to borrow against your 401(k). There are short repayment periods, penalties for missed payments, the risk of a job loss triggering full repayment or treatment as a taxable withdrawal (and possibly subject to early withdrawal penalties), the opportunity cost of a lower investment balance in a rising market, expenses, and double taxation of interest. These are some serious downsides and I agree that the 401(k) isn’t the first place I’d go to borrow money.

But, when would it be worthwhile?

If you are overwhelmed with credit card debt at high interest rates, it might be worthwhile to borrow from the 401(k). I have met with people who are in very dire circumstances with debt and when looking at their entire financial picture, taking a 401(k) loan can drastically reduce the interest they would pay over the life of the loan. When minimum payments are all that can be made on high interest credit cards and the likelihood of paying off the cards in full anytime within the next 20-30 years looks negligible, then it’s a consideration. The interest rate is low and credited back into your own account and there is no credit check so there are no inquiries reported to the credit bureaus. If your credit score leaves a lot to be desired, this could hasten the payoff of your overall debt level while increasing your credit score as a side benefit. The key to this strategy is changing the behaviors that led to the accumulation of the credit card debt in the first place. If those behaviors don’t change, this is a recipe for disaster because I’ve seen people do this and end up maxed out on all their credit cards again less than a year later.
When you have a short term funding need, feel good about your job security and have very solid cash flow. An example of this that I’ve seen recently is when someone has needed to pay an attorney to get a divorce finalized but had no money in savings. There was a very realistic expectation that a property settlement during the divorce would more than pay off the 401(k) loan. In that case, without the loan, the divorce could have dragged on indefinitely. With the loan, the proceedings could move forward quickly and the loan could be paid off at the conclusion of the proceedings with money from the other spouse. This was indeed an interesting situation, but it was entirely appropriate in spite of all of the negatives usually associated with 401(k) loans.
When purchasing a home and the only way to avoid PMI is to come up with a little bit more money for the down payment. Rather than paying PMI for years with absolutely no payback, a 401(k) loan instead could instantly add to the equity in the home, eliminate PMI and provide a positive addition to one’s financial life.

In most cases, taking a 401(k) loan is a bad idea…a really bad idea! Most financial planners, financially savvy individuals and people who understand how the world works will tell you that you should never borrow from your 401(k). But one rule I live by is that the words “ALWAYS” and “NEVER” should never be used (except in this context).

I agree that it is usually not a tactic I would advocate, but there are some circumstances when it makes more sense than most other options. The three options above are not an all-inclusive list of times when a 401(k) loan might make sense, but they are circumstances that I’ve seen in which it made sense to the individual taking the 401(k) loan. Don’t necessarily run out and get a loan against your 401(k) tomorrow, but if you see yourself fitting into one of these situations or something similar, reach out and ask a financial expert if your circumstances warrant considering a 401(k) loan. You might want to print this out so they can see the logic behind your request and you don’t get an immediate “No!!!” from them.