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The Pro's and Con's of Taking Out a 401k Loan

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A common dilemma in a down economy is as follows: you need to borrow money but, with lenders tightening their credit requirements, the loan options are few and far between. What do you do? For a growing number of people the answer may be taking out a 401k loan (i.e., borrowing directly from your personal 401k retirement plan). After all - you may say to yourself - it's my money anyway and if I choose to put some of it to use now, what could be the harm?

Sounds like a good plan. But does it make good financial sense to borrow from your 401k? The answer is not as clear cut as one may think. The truth is that, in many situations, accessing one's 401k for a loan may not always be the best decision. Statistics show that a 401k loan, even after the loan is repaid, tends to reduce one's 401k account balance.

Consumers need to consider several factors before making the decision to take out a 401k loan. One should weigh the need for funds vs. the options available, and the resulting effect on any retirement plans. Borrowing from a 401k plan indeed has some notable benefits, yet the potential negative effects are often overlooked. Having a clear understanding of the pro's and con's of taking out a 401k loan will better prepare you to make a decision with which you can feel comfortable.

401K Loans - A Brief Primer

Federal law does not restrict the borrowing of funds from a 401k plan. However, an employer is not required to offer this feature. In particular, many small businesses, for the sake of reducing overall plan costs, choose not to allow their employees to take out a 401k loan.

Hewitt Associates conducted a survey during the summer of 2009 to gather data on several aspects of 401k's. They found that nearly all the plans surveyed (97%) have a loan provision, with 99% of these plans offering general purpose loans and 77% offering home loans. Those numbers are consistent with surveys from recent years. According to the Employee Benefit Research Institute, slightly less than 20% of 401k participants have a loan - a figure largely unchanged over the recent past history. The average unpaid balance at end of 2008 was $7,192, slightly lower than the $7,495 reported at the end of 2007.

If an employer does offer a 401k loan option, they can restrict what the loan will be used for. Most plans commonly allow borrowed money to be used pay medical fees, tuition expenses, alleviate hardship (e.g., avoid foreclosure), or to purchase a home. The period to pay back the loan normally does not exceed five years, except in the case of a home purchase. Most plans offer an interest rate of 1 or 2 percentage points above the prime rate, with the typical maximum loan amount being the lesser of $50,000 or 50% of your vested 401k account balance.

Pro's of a 401k Loan

  • Fast, easy and convenient. Since you are, after-all, borrowing your own money - there is no credit check or security required. Repayment process is a snap - it's normally done via automatic deduction from payroll check
  • Low interest rate. The 1-2 percentage point over prime is much lower than you would expect to see on most personal loan products.
  • Payback flexibility. Typical payback period is fairly short. Yet, if you choose you can repay the loan with no penalty assessed.
  • Interest cost is tax sheltered. Simply put - you don't pay taxes on the interest until you've retired and started taking money out of your 401k.
  • Did we mention that you're borrowing your own money? Hence - the interest paid back on the loan goes directly back to your 401k account.
  • As long as you pay the loan back, and on time, you won't have to pay any penalty for taking funds out of your 401k.
  • Interest paid goes back into your 401k account

Con's of a 401k Loan

  • Opportunity costs. The money borrowed comes straight out of your 401k account - and over time you may not realize the full potential value of your principal. In other words, the money you borrow from your account is no longer working for you, and therefore, loses the potential to grow. Most studies show that the interest paid back on a loan is less than what would have been earned had no loan been taken out. Of course, if you are able to continue making the full 401k contribution while you are repaying the loan, then you maintain your investment growth potential. The problem is that few people choose to, or are able to, do this while also repaying the loan.
  • Interest is not tax deductible - as it is on a home equity loan.
  • If you end up not paying the loan back be prepared to pay a 10% penalty (if you under the age of 59 ) as well as federal and state taxes on the amount.
  • If you leave your company - for whatever reason - the plan may expect you to repay the loan immediately.
  • Fees - depending on the plan, the will most likely be some sort of fee...albeit normally a nominal one.
  • Double taxation on the interest. The loan is paid back with after-tax money - and once you retire and start drawing off the 401k you'll pay be taxed again. Your normal 401k contributions are made with pretax money.

Final Thoughts

It's no secret that the recent credit crisis has drastically altered the lending landscape, making it difficult for many people to borrow money. If your loan options are few, and the need for funds is real, a 401k loan can be a wise choice. Still, if at all possible, consumers should always refrain from leveraging their 401k in the following situations: if you believe you may be leaving your current employer in the next two years, if you are nearing retirement, if you can obtain the funds through other means, and if the purpose of the loan is for a "luxury" - or something you could do without.