When it comes to finding money, your options are often limited. Banks have made it difficult for the regular guy to borrow money, and unfortunately, other forms of financing are often expensive. Because of past credit issues, more and more people find that they are unable to locate financing at all. So, just what are your options if you are having trouble finding financing?
We’ve highlighted some ways to getting a personal loan before, and we’ve discussed various options, from the most favorable to the least. For example, we prefer peer to peer loans because of their relatively lower personal loan rates, but another option exists for those who are finicky about interest rates. Of course, it has its downsides, and I am personally uncomfortable about taking this approach, but other folks have been more than willing to go this route. So what loan am I talking about? It’s the 401(k) loan. This approach is primarily known as “borrowing against your 401(k)”.
What’s A 401K Loan?
Well, if you are fortunate enough to have an employer that offers a 401(k) plan and you have been diligently saving, you can borrow from your retirement account. You can borrow the money from your own account and as you pay this loan back, the interest you pay will be deposited back into your account. Now, you will only be allowed to borrow 50% of your account balance and the upper limit is $50,000, but if you need to find some money in a hurry, this may be the solution for you, provided that you really understand the risks and take all those into account. This approach can only be treated as a last resort, but only then, with the acceptance that you can potentially harm your retirement fund. At any rate, here’s how it works:
1. You request a loan from your 401(k) administrator. The form is generally much shorter than your typical loan application form.
2. The funds will be dispersed to you via check or direct deposit into your checking account, and you will receive the terms of repayment. In most cases, you will make regular payments to your 401(k) via payroll deductions that include principal and interest. You will be charged interest, which will usually amount to prime plus one to two percent. You won’t be assessed any penalties on the disbursement as long as you make your regularly scheduled payments.
3. If you terminate your employment, the remaining balance of your loan will be treated as regular income and will be subject to income tax as well as a 10% penalty for early withdrawal. You’ll also be required to pay off the loan within 5 years unless you’re buying a primary residence (which may qualify for a longer payback schedule).
Pros of Borrowing Against Your 401K
So, now that you know how a 401(k) loan works, here’s why you might consider using one in order to satisfy a financial obligation:
1. There are no credit underwriting guidelines. This means that as long as you have the funds available in your 401(k), you will be approved for the loan. You’ll simply be accessing your own money under certain provisions. This is extremely helpful for people with bad credit.
2. The interest rate is low. In most cases, the interest rate is lower than anything you could expect to get from a bank, no matter how good your credit is. And a 401(k) loan is always less expensive than non-bank lenders.
3. The interest payments go into your account, thus increasing your balance after the loan is repaid. Typically, it won’t have much of an effect on your account if you can stick to your repayment schedule. There could be some effect though, if you are invested in stocks while the market is moving strongly in a particular direction. If the market is falling, then the loan may actually work to your advantage. Either way, the effect may not be significant if you pay yourself back.
4. You can use the loan for whatever you want.
5. You won’t have any tax or credit rating impact when you borrow from your account.
Cons of Taking Out 401K Loans
But, with the good comes the bad. Here are a few of the drawbacks of getting a loan from your 401(k).
1. The money you take out will no longer be earning you a respectable return on your investment. This is especially the case in a positive market. If the market is trending upwards resoundingly, then removing money from your retirement account can impede the growth of your funds.
2. Defaulting on a 401(k) loan is extremely expensive. Not only will you have to pay regular income tax on the money, but you will have to pay a 10% penalty fee for early withdrawal.
3. The interest on your loan is not tax deductible. This is because the money you are borrowing is already being distributed tax free.
4. The repayment terms are fixed and because they are payroll deducted, you have no opportunity to make late payments. There’s less flexibility with the loan terms here.
Now, with all of that being said, I have used the loan feature of my 401(k) plan to consolidate and pay off high interest debt. I was willing to accept the risks to my retirement future in order to get my current financial situation under control. I felt that this was the best financial decision I could make. However, if I were looking to find a way to finance a home improvement project or a vacation, I would look elsewhere. This is because I am not willing to jeopardize my financial future so that I can go to the beach today.
Taking out a 401(k) loan is a serious undertaking and should not be taken lightly. Consider all of the pros and cons, and all other financing options that are available to you before deciding that this is the way to go.
Created March 2, 2008. Updated July 7, 2011. Copyright © 2011 The Digerati Life. All Rights Reserved.