Ask most financial advisors about borrowing from your 401(k), and their response will be brief and blunt: “Don’t do it.” Those three words mostly sum up the prevailing sentiment on the subject. Still, there are some situations in which borrowing from your 401(k) might make sense. If you’re considering taking out a loan against your plan, know the pros and cons first. [Read related article: 401(k) Plan: What It Is and How to Choose One]
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How do you determine if you should borrow against your 401(k)?
Before you begin the process of borrowing against your 401(k), you need to think through the strategy. Here are some questions you should ask yourself before proceeding:
Am I eligible?
The answer depends on your employer’s plan. Employers are not required to allow loans against retirement savings plans. Some plans don’t, while others allow multiple loans. Most, though, have a minimum amount you are allowed to draw from your 401(k). Check with your plan administrator, or read your summary plan description to find out if a minimum applies and, if so, what that amount is.
How much money can you borrow?
Minimum loan amounts vary, but the maximum is $50,000 or 50 percent of your vested balance — whichever is less. Vesting rules also vary, so check with your plan’s administrator.
What is the cost?
In addition to the money you lose by reducing your earning potential (more on that later), you must pay interest. However, the interest rates on 401(k) loans can be very attractive compared with those for other borrowing options.
How long before I must repay?
Typically, you must repay in one to five years, unless the loan is for the purchase of a primary residence. A repayment schedule will be part of the loan agreement. For details, check your plan.
Before you begin the process of borrowing against your 401(k), find out whether your plan allows it, how much you can borrow, what the interest rate is and how long you have to repay.
What are the pros of borrowing against your 401(k)?
Although many financial planners and money managers advise against borrowing from your 401(k), there are some pros of doing so:
- You don’t have to apply. Because you are borrowing money from your own retirement savings account, there is no loan application to fill out. Nor do you have to provide reams of documents, a business plan or other paperwork, all of which are required for small business loans. [Considering a small business loan? Check out our picks for the best business loans.]
- Your credit score doesn’t matter. There is no due diligence when you’re borrowing against your 401(k), which means it doesn’t matter if you have a bad credit score. Repayments aren’t reported to the credit rating agencies, either, which ensures that your credit score remains intact.
- It doesn’t change your debt-to-income ratio. Money you borrow from a 401(k) isn’t added to your debt balance on your credit report. That’s important if you want to take on a car loan or a mortgage. The more debt you have compared with your income, the less likely a lender will be to approve you for a loan.
- The interest rate is typically lower. When you borrow against your 401(k), it is a loan, which means you are required to pay it back with interest. However, the interest rate is usually much lower for a 401(k) loan than for a bank or alternative lender’s loan. Moreover, you’re repaying yourself, not a bank, so the interest is being paid back into your 401(k).
- Repayment is automatic. There’s no risk of missing a payment with a 401(k) loan, because the payment is an automatic payroll deduction.
- There are no penalties. Unlike with an early withdrawal from your 401(k), there are no penalties or taxes owed if you take out a loan against your 401(k). There is one caveat, however: You need to pay it back on time.
Pros of borrowing against your 401(k) include the lack of a credit check or application, a lower interest rate than with a bank loan, automatic repayment and no penalties if you pay it back on time.
What are the cons of a 401(k) loan?
Here are the biggest reasons for keeping your hands off that nest egg:
- Your earning potential could take a big hit. Missing out on growth opportunities is the primary and most obvious reason to avoid borrowing from your 401(k). Over time, your managed investments will tend to grow. The more dollars you have working for you, the more you can make. Pulling money out reduces your earning potential. The closer you are to retirement, the harder it is to catch up. However, if you take out a 401(k) loan when the market is down and pay back the loan before the market recovers, you may avoid this downside.
- When you repay the loan, your take-home pay is reduced. Eventually, you have to repay yourself, and that’s hard to do when you have an additional payroll deduction. Most loan terms range from one to five years, and payments come from payroll deductions using after-tax dollars. This decreases your take-home pay.
- You’re locked into your job for the duration of the loan. Changing or losing your job means you’ll have to repay the debt. While it’s true that the Tax Cuts and Jobs Act gave job changers more time to come up with the funds, it didn’t remove the requirement to repay the loan. Regardless of your plan’s wording, you have until the tax-filing deadline to get that money into an IRA. If you miss the deadline, the outstanding loan amount will be considered a distribution, and you will be liable for not only the taxes but also a 10 percent early withdrawal penalty (assuming you’re under 59 1/2 years of age).
The biggest downside of borrowing against your 401(k) is the hit to your retirement earning potential, as you can’t grow or contribute to these savings while you repay the loan.
If you borrow from your 401(k), do it wisely
There are times when borrowing from your 401(k) may be a smart move. If you’re using it to pay down high-interest debt at a time when the market is low and your rate of return is negligible, you may come out on top. However, if you’re pulling from your 401(k) when it is generating big returns and you use the money for some frivolous purpose, you could be jeopardizing your retirement. Before you take out a 401(k) loan, consider your reason for doing so and the current economic landscape. If you’re smart about it, though, your 401(k) could be a useful source of liquidity.
Donna Fuscaldo and Tejas Vemparla contributed to this article.