401K Loans & The Pros and Cons of Borrowing Against Your 401K

by Alexis A. on 2011-07-0710

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.

{ 10 comments… read them below or add one }

Single Ma July 7, 2011 at 4:02 pm

I don’t think it’s ever acceptable to use the 401k loan feature, unless I have no money for food or I’m about to be homeless.

You stated…

“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.”

Then said…

“…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.”

I take it your “high interest” debt was not credit card and other consumer debt. If it were, you jeopardized your financial future for things worse than a beach trip.

Silicon Valley Blogger July 7, 2011 at 4:12 pm

Hi Single Ma, Great comment!

I personally think that a 401k loan as well as home equity loans are pretty risky as you have something to lose here. Some people (including Alexis) have tried it and from her story, she’s satisfied with how it turned out for her. To have it make sense as an option, you have to ensure you’ve got strong cash flow and the numbers make sense: e.g. credit card rates are high while your investment yields are subpar. Make sure you are at least coming out ahead and you are well aware of the risks you are taking for that gain you are aiming for. Personally, I would not touch my accounts with a ten foot pole. I just don’t do debt.

I find that a lot of people are more than willing to play with loans and financial loopholes that are available to them despite what seems to be their high risk nature. Case in point: I know a very successful guy (VP of a major bank) whose emergency fund is basically his credit card line. So what possesses people to pull stuff like this? They apparently understand the risks and are willing to face the consequences of their decisions. Another crazy ploy is to do credit card arbitrage. You’d think it was an insane scheme to make money via cards. But apparently, people have succeeded by running the numbers. There are bloggers who are experts at that game, especially when the credit industry was so loose about their qualification requirements in the past.

But you are right about pointing out the risks. Unfortunately, some people find that they no longer have any other options but to raid their 401K. For such a situation, there really is no other choice but to forget the loan and instead opt for a pure hardship withdrawal. But that’s another story.

Cassie July 8, 2011 at 8:07 am

I agree with Single Ma and Silicon Valley Blogger, 401K loans are way too risky.

Let us look at a worse case scenario here.

Borrow 25k from your 401K to pay off high interest credit card debt, but before repaying you lose you job, you now have 60 days (normally) to repay the loan but of course you cannot repay it — you borrowed it because you had no other source of funds.

Now you will pay the 10% penalty AND you will pay taxes on the full amount as regular income — all at a time when you have no money!

I hope you find a new job quickly but you might not. Those credit cards were unsecured. Had you been unable to pay them due to prolonged unemployment, you may have settled them for 50 cents on the dollar or worst case never paid them. Either way your 401K would be sitting there growing for your future retirement.

Alexis, I am very glad your 401K loan worked out for you but many others have not been so lucky.

Randy Schaller July 8, 2011 at 11:47 am

I believe that 401k loans should be avoided in almost every scenario. It has been my experience that most financial problems do not get resolved by taking on additional debt, even if it is theoretically your money that you are borrowing. Due to the shortened repayment period required for a 401k loan, the monthly payments could be significant depending on the amount borrowed. A significant reduction in take home pay while attempting to repay the loan may only create more problems. As Cassie commented, you have to consider the worst case scenario and in this case you could find yourself in a much deeper hole than had you not taken the loan.

Silicon Valley Blogger July 8, 2011 at 12:36 pm

Thanks for all your comments. I believe the discussion on risk here cannot be emphasized enough. The issue here is whether anyone should do something as “radical” as tapping their 401K. There may be a rather small group of people who can benefit from something like this if they really know what they are doing — but it boils down to “timing”. For example: someone has some high interest debt. They have a 401K invested in the stock market, but the market is looking shaky. They make the decision to pay off their high interest debt by taking out a loan against their investment fund. This can work out to this person’s benefit if the market tanks sometime in the future, and they’re able to pay off that debt very quickly and without issue (in effect, “selling high and buying low”).

But how many people have the discipline to replenish their retirement funds after taking out these loans? Probably not very many. When we make a financial decision, we want to make it from a position of strength rather than of vulnerability. If you are making the decision because it’s strategic, then it could be a good move. If it’s because you’re desperate, then chances are, the decision can lead to a situation that ends badly.

Individual 401K July 11, 2011 at 9:30 am

As much as possible, never borrow from your 401k if you won’t be able to catch up or comply with the terms. I have know a lot of people who got into trouble because of this issue. Yes, it has its advantages as discussed on this blog, however, the disadvantages are more devastating.

Michael Harr @ Living TodayForward July 18, 2011 at 4:35 pm

Certainly it’s preferable to avoid dipping into a 401k whether through a loan or a hardship withdrawal. However, if one is experiencing real financial pain, a 401k loan or withdrawal can be a life (home?) saver. It’s difficult to get too upset when someone takes out a loan because a significant other has found the unemployment line or some other major financial shock has come home to roost. Loans and withdrawals are available for exactly these purposes.

Of course, in a perfect world, everyone would be gainfully employed, spend much less than they make, and have all of the appropriate insurance coverage before ever putting a dime into a 401k:) In lieu of perfect, we have plans B and C – loans and withdrawals, respectively.

Rachel Skeens July 20, 2011 at 11:48 am

My four year old has recently been diagnosed with a metabolic disease that requires all food, medications, and supplements be ordered, we have outrageous medical bills and we are about to lose everything we have. We have asked our 401k through my husbands work to borrow from it and they are giving us a really hard time about it. Even under these circumstances they are saying we can apply but may not be approved to borrow from our 401K. What I am not understanding is this is my husbands money — he has earned in the past 12 years, if we need it, why cant we have it? Is there anything we can do? At this point, this is our last resort before we lose it all.

Silicon Valley Blogger July 20, 2011 at 12:32 pm

As far as I know, if it’s your money, you should be able to take it out. But in some situations, the funds in your account may not be properly vested or there is something else going on in this account. There can be penalties and tax implications behind dealing with 401K money so there could also be other measures in effect that may prevent you from consistently borrowing against a fund. At any rate, you should find out the exact reasons for being unable to get access — there may be some eligibility issues and provisions that you are tripping up. If they can’t give you sensible reasons or an explanation, you may want to seek legal help.

Anyone else have thoughts on this?

Kevin@RothIRA August 25, 2011 at 5:40 pm

Everyone seemed to be taking 401K loans back in the 80s and 90s–people even got comfortable doing it. You were borrowing from yourself at the lowest rate possible. It had become the preferred FIRST loan source!

But back then employment was more predictable, you could count on being on a job five years or more to cover the payback. Today that’s gone. No one can assume they’ll be on a job that long, not today. The 401K loan has really come down to the consideration of job stability first and foremost. That should make it a no-go for most people.

It makes a strong case for funding a Roth IRA, since you can take the contributions out penalty and tax free well before retirement. In a way, the Roths may be the 401K loan source of the 21st Century. Even though it isn’t a loan, it can serve the same purpose, and without the pressure of tax consequences.

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