A 401(k) loan is a method of borrowing money from your retirement fund. The money is paid back with interest through payroll deductions, with the interest also going toward paying yourself back. Eligibility for 401(k) loans depend on the rules of your employer's retirement plan, as do the terms of the loan itself. While some plan rules allow borrowing of a certain percentage of the 401(k) funds for just about any purpose, others put restrictions on what the money can be used for – such as purchasing a home, medical expenses or funeral expenses. You will most likely need to show a financial need to borrow from your retirement, including documentation of your situation and intent for using the funds.
As with any financial decision, deciding to borrow from a 401(k) retirement plan should not be one you make lightly. Be sure to weigh the pros and cons carefully before signing any paperwork to borrow money from your 401(k).
Disadvantages of 401(k) Loans
When you take a loan from your retirement fund, even though you pay yourself back with interest there is a good chance that you will end up with less money when you retire because you will miss out on market gains on the balance you borrow. One of the primary benefits of using a retirement plan such as a 401(k) is the value of compounding interest. Over time, the interest on the balance of your account grows and accumulates. When money is withdrawn from the account, you reduce the balance that is available for compounding. As the money is repaid slowly, the rate in which your money can grow is reduced.
In addition, if you should lose your job before the loan is fully repaid, you can be required to pay the entire loan back quickly, sometimes in as little as two months time.
Another disadvantage of borrowing from your 401(k) plan is that you essentially get taxed twice. You are taxed on the money you use to pay the loan back, since it's taken from your payroll check on an after-tax basis, and then you are taxed again when you retire and withdraw the money after the age of 59 and ½. This is because when you contribute to your 401(k) plan, the money is taken from your account on a pre-tax basis – so the taxes are paid when you withdraw the money.
While interest paid for a 401(k) is returned to your retirement fund, most 401(k) plans charge a loan origination fee that can be around $75, regardless of how much you borrow. A small loan of $1000 with a $75 fee means you lose 7.5% right off the top!
Advantages of 401(k) Loans
The pros of borrowing money from a 401(k) plan are what lead many people to look at this option for obtaining cash. There is less paperwork required than other types of loans, with a 401(k) loan requiring just a few short forms to specify how much you are borrowing and from which investments you'd like to convert to cash. When you are approved for the loan, the funds are automatically deposited into your bank account. Because there are no credit checks required for borrowing from your 401(k), it becomes a good option for individuals who have less than perfect credit to borrow money at a reasonable interest rate. The interest rate for 401(k) loans is usually lower than other loans to begin with, at a rate around prime plus 1%, but even the interest you pay is going back into your retirement account so most people aren't overly concerned about the actual interest rate itself.
Finally, another advantage of taking a 401(k) loan is that your credit remains unaffected if you default on the loan for any reason.