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5 Things To Know About a 401k Loan

Considering taking a 401k loan? If you really must, here are 5 things to know.

If you’ve been saving as the years go by, that once formerly-wimpy 401k account has started to fill up. It’s easy to start wondering – could I do something with this money right now?

The answer is yes. However it is an extremely hesitant, very cautious yes.

401k loans do exist, and they’ve helped plenty of people out of a bad situation. They’ve even helped some capitalize on an amazing opportunity. But before you get on the phone to your 401k provider, understand that misusing a 401k loan can have severe consequences – some of which you may not realize until it’s too late.

You’re Sacrificing Years of Growth

When you borrow from your 401k, you essentially take away that sum’s ability to grow. This potential growth you lose can put a damper on your retirement plans.

If you do plan to borrow from a 401k, try to pay it back as soon as possible or ensure that the loan is earning you money in some other way. For example, Certified Educator in Personal Finance® Jackie Cummings Koski borrowed $50,000 from her 401k to purchase a condo that she later sold at a 40% profit.

“It paid off big time for me, but I would only [take out a 401k loan] where a great opportunity exists,” she said.

You Pay Interest to Yourself

One of the benefits of 401k loans is that any interest you pay goes into your 401k instead of to a lender. This is a primary reason why some people, if there isn’t an alternative, recommend choosing a 401k loan instead of getting a personal loan or using a credit card.

However, CFP® Melissa Sotudeh of Halpern Financial said this shouldn’t be the only reason you take out a 401k loan.

“This is more attractive than the interest payments going to a lender, but don’t be fooled that you are fully making up the difference,” she said. “By paying interest to yourself, you’re getting back to the amount you had before taking the loan, but you’re still sacrificing the growth that could have occurred if no loan was taken out.”

You May Have to Repay the Loan Quickly

In general, 401k loans have shorter terms than other loans. It is often a five-year maximum term, but it can be even shorter than that.

Because 401ks are tied to your employer, you have to repay the loan if you’re no longer employed. Sotudeh says you usually have 30 to 60 days to pay back the loan or it’s treated as an early withdrawal. If that happens, you’ll owe taxes on the balance and a 10% penalty on the outstanding balance if you’re less than 59.5 years of age.

Because of these terms, 401k loans may make work mobility more difficult when they are outstanding. If your partner gets a better job offer out of state or you’re offered a better position from a competitor, a 401k loan with an outstanding balance can limit your options and leave you scrambling for money.

You Can Borrow a Large Amount

Financial and estate planning expert Ryan Brown said most people aren’t aware that 401ks have large loan options.

“Many people believe that the amount of the loan will generally have to be very small,” he said, but most allow you to borrow 50% of the balance, up to $50,000 total. That can be enough for a home renovation, a down payment on a second home or part of your child’s college education.

Unless you have a home with lots of equity, a 401k loan may be your best – and only – chance to borrow such a large sum.

You May Not Be Eligible

While many 401k providers allow loans, not all do. Some only permit them in hardship cases, which include possible eviction, large medical expenses or funeral costs. Each plan will differ in what they allow you to use the money for.

If those are the only instances where your 401k provider allows loans, you may not use the funds for any other purpose – such as buying a home or paying your child’s college tuition.

You Should Try To Find Another Way

Despite all the existence of 401k loans, many financial experts advise that you steer clear of them. Not only can you find yourself without a job and having to pay back the loan within two months – you also forego years of growth that could fund your retirement.

“Borrowing from a 401K may make sense due to a medical emergency, home foreclosure or job loss,” said Debt Free Guys co-founder John Schneider. “Under any other circumstance, borrowing from a 401K likely doesn’t make sense.”

In other words, a 401k loan isn’t always a bad idea – there’s just almost always a better option. Do your research, talk to a financial advisor and try to avoid risking your retirement over a temporary setback or opportunity. Your senior self will thank you.

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