You've been setting money aside for retirement with a 401(k) and there's a good amount of money in there now.
There may be a financial emergency that requires a large sum of cash. And, you're considering borrowing from your 401(k).
While a 401(k) loan appears to be a great a cash-strapped borrower, there are definite downsides that may sway you toward other loan options.
Find out when it makes financial sense to take out a 401(k) loan.
How Does a 401(k) Loan Work?
A 401(k) loan works just like any other type of loan.
But instead of borrowing money from a bank or credit union, you’re borrowing from your own retirement savings.
Since you’re borrowing from yourself, you’re also paying back yourself over a period of time.
It’s important to realize that this isn’t free money.
You’re typically given up to five years to pay back the funds.
The only exception:
You’re borrowing from a 401(k) to purchase a primary residence. If so, you may receive a repayment schedule up to 15 years.
Depending on how much you have in your account, borrowing cash from a 401(k) can make homeownership a reality sooner rather than later. Instead of spending the next 5 to 10 years saving up for a down payment, you can borrow from your retirement account and buy now.
Not offered by all 401(k) administrators
Be mindful, though, that a 401(k) loan is only an option if your employer’s plan allows loans.
Speak with the company’s plan administrator beforehand to make sure you understand the rules regarding these loans.
This is important because the plan might not allow additional contributions until the 401(k) loan has been paid off.
How much you can borrow
If you’re allowed a 401(k) loan, you can typically borrow up to $50,000 or 50 percent of your vested account balance, whichever amount is lower.
Why 401(k) loans are attractive
A 401(k) loan isn't the only option when you need a loan for home improvement, medical expenses, emergencies, and other uses. Many people go to a bank or credit union and complete a loan application.
But although these are common sources for a loan, getting approved for a loan is challenging if you don’t have collateral or a high credit score.
Others also consider using a credit card.
The problem, though, is that many credit cards have high interest rates.
That said, a 401(k) loan is often a cheaper alternative.
What is the Cost of a 401(k) Loan?
Yes, this is your money. But a 401(k) loan isn’t exactly free.
Remember, this is a loan that you’re repaying yourself. And like any other loan, it involves interest.
The best part:
Rather than pay interest to a bank, the interest you pay goes back into your retirement account.
This fact alone can make a 401(k) loan more appealing than a bank loan.
Because while taking money out of a 401(k)—even temporarily—can undermine your savings, there’s also a chance that the interest paid into the account will be more than any lost investment earnings.
If so, taking a loan doesn’t necessarily slow the growth of your account.
Along with interest, be aware of fees associated with a 401(k) loan.
Fees vary but tend to be low.
In most cases, you can expect to pay a loan origination fee or a loan administration fee.
This is also common with a bank or credit union loan. Yet, the fees with a 401(k) loan will likely be less.
What Is the Penalty for Not Repaying a 401(k) Loan?
Even if you have every intention of repaying the loan, you could fall on hard times later on, which prevents keeping up with the payments.
So it’s worth noting:
You don’t "have" to pay back a 401(k) loan—although you should.
But before you skip out on repaying your retirement account, there are a few things you need to know about penalties.
Early withdrawal penalty
When you get a loan, you’ll receive a set interest rate and a set repayment plan, typically over five years.
Because this is a loan and you’ve agreed to pay back the money, you don’t get hit with an early withdrawal penalty, nor do you pay taxes.
On the other hand, if you don’t repay the loan, you will have to pay a 10 percent early withdrawal penalty, if you’re under the age of 59 1/2.
This is because failure to repay the loan principal switches the transaction from a loan to a withdrawal.
In addition to a 10 percent early withdrawal penalty, you’ll also pay income tax on the amount withdrawn. Taxes paid are based on your tax bracket.
You can avoid the early withdrawal penalty, however, if you're eligible for a hardship withdrawal.
This can include needing cash for a medical expense, funeral or burial expenses, certain home repairs, tuition, or to prevent an eviction or foreclosure.
Leaving your job before full loan repayment
It’s also important to keep in mind that if you leave your employer before paying back a 401(k) loan in full, you’ll have to repay the entire outstanding balance sooner.
It’s typically due before the next due date for federal income tax returns.
So if you have three years left on your 401(k) loan and you quit or lose your job in January, you would have until April 15 of that same year to repay the loan, if you want to avoid taxes and an early withdrawal penalty.
This is a new rule.
Before, you had to repay the balance within 60 days of leaving a job.
Pros and Cons
A 401(k) loan might seem like a great option when you don’t have other alternatives.
But make sure you carefully weigh the pros and cons of this decision before speaking with your employer.
No credit check
Whereas a bank or credit union will check your credit history to see if you’re eligible for a loan, there’s no credit check with a 401(k) loan.
There’s also no loan application and your employer doesn’t report the debt to the credit bureaus.
No prepayment penalty
Even though the loan has a set repayment schedule, you can always pay off the balance sooner without penalty.
Also, the loan is made through payroll deductions. So you don’t have to worry about late payments or missing a payment.
The interest and fees with a 401(k) loan tend to be cheaper than the fees and rates charged on credit cards and personal loans.
You’re able to use the money for just about any purpose.
Smaller contributions until you pay off the loan
Keep in mind that a percentage of any new contributions are used to pay off the loan.
Therefore, you’ll contribute less to your retirement account until you’ve paid off the loan balance.
Forfeit potential gains
Even with a temporary loan on a short-term basis, you could still miss out on new investment growth.
When Does It Make Sense to Use a 401(k) Loan?
Despite the potential drawbacks of a 401(k) loan, there are times when it does make sense to borrow against your retirement account.
When standard options are not available
These loans are certainly an option if you’re struggling and need to get your hands on immediate funds.
Using your savings account might not be an option.
Also, you might not be eligible for a personal loan or a home equity loan or line of credit.
And even if you are eligible for a home equity option, you may prefer “not” putting your home at risk, especially since you could lose your property if you default.
For the short term
A 401(k) loan also makes sense when you only need a short-term loan.
Even though you’re given five years to repay the loan, you might be able to repay the loan much sooner, say in a couple of months or years.
In which case, you can put the borrowed money back into your account without the loan having a huge impact on your retirement grow.
Plus, you’ll pay little interest with a short-term loan.
A 401(k) is an excellent tool for saving for retirement.
You can choose how much of your paycheck to contribute, and in some cases, your employer may match your contributions.
But while the idea is to grow your retirement savings without tapping the funds, it might make sense to take a 401(k) loan at some point.
Before doing so, though, make sure you understand the fees, interest, and penalties associated with these loans.
Since you could lose some investment growth with a loan, come up with a plan to pay it off as soon as possible to avoid losing years of compounding interest.