Chances are that if you’re reading this, you’re probably considering taking a 401k loan, and you’ve most likely heard that it’s something to avoid. Generally speaking, we agree, but there are definitely reasons that it can make sense. Otherwise, why would the option even exist, right? Let’s go over the key things to consider so you can make the best decision for you and your future.
Why 401k loans get a bad rap
Let’s get the downside out of the way first so you can make an informed decision. The overarching reason that 401k loans get a bad rap is that there is a risk that loans can compromise your ability to retire when you want to. Here’s how:
Loss of growth potential of your money
Most likely, your 401k account contributions are being invested in the market for long-term growth. When you borrow that money, you’re taking it out of the market and missing out on the chance for the money to grow while you’re paying it back. The actual impact of this will depend on how your money is invested as well as what happens in the market while your loan is outstanding, but the more you borrow and the more often you borrow, the more this effect shows up and damages your retirement.
When you leave your job before it’s paid back
Some companies allow you to continue making payments on your loan if you leave your job before it’s fully paid off, but many require you to pay it back within 30 – 90 days after you leave. If you’re not able to, then it’ll be reported as a distribution and you’ll end up paying taxes on the amount you didn’t pay back plus early withdrawal penalties if you’re not yet age 59 ½. There are ways to stretch this deadline out by using an IRA, but make sure you understand fully how this works if you end up leaving your job with an outstanding 401k loan.
You’re typically limited to the amount and number of loans outstanding
Most companies limit the amount and number of outstanding loans you’re allowed to have at one time, which means if you have a future emergency need, this option may not be there for you if you take a loan now for something else. Deciding to take a loan comes down to understanding the alternatives you have available, which we’ll review next.
Alternatives to consider before taking a 401k loan
Whether or not these suggestions make sense will depend on the reason you’re taking a loan, but make sure you’re honest with yourself so you don’t regret this choice in the future.
Tap your emergency fund
Tapping your emergency fund is probably an obvious one, but we’re in the business of helping you find financial wellness, so we have to point out that an emergency fund is the best way to avoid borrowing from your retirement account. If you have one, consider tapping that first, since it’s highly likely that any interest you’re earning on your savings is lower than the rate you’ll pay yourself back into your 401k.
Explore using your home equity
If you have any home equity (your home is worth more than what you owe on your mortgage), consider looking into a Home Equity Line of Credit (HELOC). The interest rate you’ll pay may be lower than your 401k loan rate, and you’ll have more flexibility in making payments. This option makes the most sense in the case of financing home renovations, since you may be able to deduct the interest you pay from your taxes.
Take out a student loan for education costs
Again, this might seem obvious, but we’ve talked to many parents who started out thinking it would be better to borrow from their 401k rather than take out student loans to pay tuition costs, which could be a big mistake. For one, if the borrower ends up out of work, federal student loans offer more flexibility than 401k loans provide. But also, having your child take a loan out in their name will not only help them establish or increase their credit rating, but they will most likely be able to deduct some or all of the interest they pay on their loans.
Explore 0% or lower interest credit cards
It may seem strange to see a financial wellness company recommending credit cards, but here’s the thing: if you find yourself overwhelmed with debt and are exploring the loan as a stop-gap, don’t do it – credit card debt can be addressed in other ways and possibly eradicated in bankruptcy proceedings. 401k loans cannot. In fact, your 401k is shielded from creditors if you end up not able to make credit card payments or have to declare bankruptcy, so you’re better off not touching your 401k if you think there’s any chance you’re on that road.
When a 401k loan might make sense
All that being said, there are some instances where borrowing against your 401k is the best choice. Here are some common examples.
You’re looking to refinance higher interest rate debt
If the interest on your debt is high (approaching double digits), and you’ve already explored finding a lower rate with your creditor, then a 401k loan can help you save money and pay your debt off faster.
How to make the most of this scenario
- Make sure you’re in a place where you won’t run your debt up again. This means you’ve created a budget that provides for unexpected expenses and have an emergency fund in place or in process. Paying off higher debt with a 401k loan only to find yourself running up the debt again will leave you much worse off, so commit to no more new debt until you’re totally debt-free.
- Make sure you can afford the payment. Because 401k loans typically have a limit of 5 years or less, you may find your loan payment to be higher than your minimum debt payments. Make sure you can afford the hit to your cash flow, or you could find yourself accumulating more debt in order to stay afloat.
You need cash quickly
If you find yourself in a circumstance where you need cash quickly, like a medical emergency or a tuition bill that’s due before the loans come in, then a 401k loan can help bridge the gap in a pinch. Since the loan is secured by your retirement plan balance, you are essentially functioning as your own bank. This means no credit check. Also, the loan does not show up on credit reports, which avoids affecting your credit score.
How to make the most of this scenario
- Commit to paying it back as soon as possible. Lots of people borrow from their 401k with the intention of paying it off quickly, like when tuition is due next week, but the student loans won’t be in until next month. Avoid the temptation to drag it out longer and stick with your original plan to avoid regrets.
- Make sure you borrow enough to set yourself up for long-term success. If your reason for borrowing is dire like you are in danger of defaulting on your student loans (which often don’t go away in bankruptcy) or you’re facing eviction or foreclosure, consider borrowing enough to hold you over in that area, plus a little extra to set aside for future emergencies. This option can help you avoid a vicious circle of crisis – debt – recovery – crisis, etc.
You’re using it for a down payment on a new home
Most 401k plans offer extended repayment terms for money borrowed for a new home purchase. Because a home is expected to increase in value over the long-term and putting enough down can keep your mortgage interest rate lower, this option can make a lot of sense as a trade-off for keeping the money invested for retirement.
How to make the most of this scenario
- Only borrow what you need. You’ll have to submit closing documents to secure the longer pay-back time, so make sure you’re only borrowing what you’re going to be putting down toward your new home purchase. Avoid the temptation to use your retirement to fund other expenses like moving fees and new furniture.
- Make sure you can truly afford to buy a home. Beyond having a down payment, you should also have a decent emergency fund, AND home maintenance/repairs savings set aside, otherwise, this can be too risky of a move for you at this point. If buying a home is a financial stretch, and you end up losing your home, you’ll also lose your down payment which will affect your retirement.
The worst reason to take a 401k loan
We’ll just call it as we see it here – if you’re regularly borrowing from your 401k to fund things like holidays and vacations, you’re doing significant damage to your finances, and it’s time to find a new way to finance these life expenses. One suggestion is that the next time you’ve paid off your 401k loan, keep making the same payment amount into a savings account. Then when holidays or vacations roll around, you’ll have cash available and you can let your retirement stay invested to build a more secure future.