I recently had a helpline call with a woman who was thinking about taking a loan from her 401(k) to pay a $32k condo assessment and avoid the 3.75% interest rate she would be charged if she made the payments over time. At first, the 401(k) loan looked like a great option. There’s no credit check, the fees and interest rate are minimal, and best of all, the interest would go back into her own account. However, there are also several hidden downsides of 401(k) loans to be aware of:
You lose out on any earnings. The stock market has averaged a 7-10% average annualized return over time. It’s easy to overlook this but it’s probably the biggest cost.
Your payments may be higher. Even if your interest rate is lower than the alternatives, your payments might actually be much higher than a credit card that will be paid off over 20-30 years. That’s because 401(k) loans generally have to be paid back within 5 years. The payments also generally come out of your paycheck so if you run into financial trouble, you don’t have the option to prioritize things like your mortgage and car payment. You also can’t eliminate a 401(k) loan through bankruptcy.
You may not be able to take another loan. This could be a problem if you don’t have an adequate emergency fund. In that case, you might want to borrow more than you need and put the extra money away someplace safe like a savings account or money market fund for a rainy day.
You may be subject to taxes and penalties if you leave your job. Any outstanding loan balance after about 60 days of leaving employment is typically considered a withdrawal. That means it’s subject to taxes and possibly a 10% penalty if you’re under age 59 ½.
You’re double-taxed on the interest. Even though the interest wasn’t paid pre-tax, it’s taxable when you eventually withdraw it. That means you’re essentially paying taxes twice on that money since you already paid taxes on it when you first earned it.
In this woman’s case, her employer’s policies provided a lot of advantages since she was able to take out up to 5 loans at a time and could continue making loan payments after leaving her job. However, we calculated that the taxes on the interest could easily add up to over $1,000 depending on the interest rate. As a result, she decided to use some of her emergency savings and reserve the 401(k) loan option for future emergencies.
If you’re considering a 401(k) loan, be aware of all the possible downsides. Make sure you also consider other options like peer-to-peer lending sites such as Lending Club and Prosper that allow you to borrow money from other people over the Internet, usually at lower rates than you can find at a bank. Finally, don’t forget that the real purpose of your 401(k) is retirement.