October 3, 2010

When its OK and NOT OK to Borrow From a 401k

Taking a loan from a 401k is an option that many of us have.   Suze Orman has vilified them on her show as a horrible idea.    Contrary to what Suze says, there is no double taxation on 401k loansPersonally I think 401k loans can have their place and be an OK idea in certain circumstances.    Usually however I think a 401k loan is not the best option.
 
First of all, what are they?   


401k loan basics

If you have a 401k at your employer then it is likely that they allow you to take a loan against the balance in your account.   Not all 401k programs offer a loan but most do.   Loans are limited to 50% of the balance up to $50,000 maximum.   The terms of the loans will vary from one company to another but generally the interest is fairly competitive in the 4-8% range and mid term length repayment timeframe.    A 401k loan is not the same as cashing out a 401k or taking a withdrawal.  You do not have to pay taxes on the loan money nor pay any penalty for early withdrawal.  You aren't cashing out your retirement, instead you're borrowing against your 401k balance technically.

Lets look at the pros and cons of 401k loans : 

Con - Pay back required if employment ends
Many if not most employers require you to repay the loan if you cease employment due to quitting, being fired or layed off.   I consider this the major drawback of 401k loans.   Generally I wouldn't want to take a loan that could be "called" by the lender without notice.   This is a major reason 401k loans are something to be wary of taking.  Worst case scenario here is that you lose your job and the same day they demand you repay a large 401k loan, so not only are you out a job you also have a large bill due.

Pro - Decent interest
The exact interest rate on a 401k loan is set by the plan.  So I can't tell you how much the interest will be.   But from what I've heard generally the interest rates charged are lower than credit cards or personal loans.   Interest rates closer to the rate on a 30 year mortgage seems typical.    Right now my own 401k is allowing loans at a 4.25% rate.  Thats a cheap way to borrow money.


Con - Undercuts retirement savings
If you leave your money in your 401k in investments then you are expecting (hoping) that they will grow over time.   If you take your money out as a loan then you are getting interest which you pay yourself, but you don't get the benefit of any booms in the stock market.   Your money can't grow in the retirement account any faster than the interest you're paying yourself.   Right now my 401k system has a 4.25% interest rate which is not a very great interest rate to be getting on my retirement.   If you have a 401k loan it may substantially reduce the growth potential of your retirement savings.


Pro - Easy access, no Credit requirements
Getting a 401k loan is relatively easy.   Theres usually no fees or very low fees, no bank approval required and you don't have to have good credit. 

Con - If you can't repay it then you owe taxes and penalties

If for some reason you are unable to repay the loan then you may be hit with taxes and the 10% early withdrawal penalty.   That could easily increase the amount you have to repay by 25-45%.


Con - Interest is not tax deductible

Unlike a home equity loan or student loan the interest payments on 401k loans provide no tax deductions.  



When it may be OK to take a 401k loan

I feel it is reasonable to take a loan from a 401k when you are not "strapped for cash" and/or if the loan is a short term loan you can pay off easily.   If you have a cash balance that is enough to repay the loan then I do not see significant risk in taking a 401k loan.  

Here are some general situations when a 401k loan is more appealing option:

Very high Interest Alternative - If your only alternatives to a 401k loan are very high interest loans then a 401k is more appealing.
Short term loans - These loans are more appealing for a 401k loan since you have less risk of worrying about having to repay the 401k loan if you lose employment.  
Stable jobs - If your job is very stable and has low risk of losing your job then 401k loans are more appealing since again you don't have to worry about repayment.
More conservative 401k investments - If the money in your 401k is in safer, lower risk investments that generally get lower interest or growth then a 401k loan is a little more appealing since you don't lose out as much in lost growth of your retirement.
Some Cash on hand - If you have an emergency fund or other cash investments that you could use to repay the 401k loan if or when necessary then you've got less risk with a 401k loan.

If most or all of these are true for you then a 401k loan could be a good option for you. 

Example:  You are 58 years old and have a secure senior position as a registered nurse at a local hospital.   You have a 9 month emergency fund and most of your 401k money is in bonds since you are a conservative investor.  Your home is underwater and your credit is not very great due to some problems after a divorce a few years ago.  Your house needs a completely new roof which will cost you $10,000.   You could pay for it out of your emergency fund but that will leave you cash poor.   You've got a lump sum of money coming sometime next year that would cover most of it but you need the roof fixed now.   The best interest rate you can find elsewhere is 9%.   The 401k loan is 4.5%.    In my opinion taking a 401k loan in this kind of situation is a reasonably good option for you.

When its NOT OK to use a 401k

Usually you shouldn't take a 401k loan.    You don't want to take the risk that you'll lose your job and then be faced with repaying a loan you don't have the cash to pay.   Plus you really should let your retirement money sit untouched and let it grow.

This is a list of situations where 401k loans are likely a poor choice:

Unsecure Job - Most of us have very little job security any more.
Other, better ways to borrow - Often we can find other ways to borrow money with reasonable rates.  Try your credit union or look for a promotional low interest rate from a credit card.  A home equity loan is often a better overall choice than a 401k loan.
Juggling debts while overspending - If your reason for a 401k loan is to pay off your credit cards and you don't have your spending under control then a 401k loan may not help you other than allow you to pile up more debt while draining your retirement.
You don't need the money - Can you get by without the loan?   If you don't need a loan then don't borrow money.

Bottom line:  I don't think 401k loans are evil.   They can have their uses in certain specific circumstances.   However I'd generally avoid them for most situations.

4 comments:

  1. Do 401K loans reduce the balance of your 401K until you pay them back? For example, if my 401K is $100,000 and I borrow $40,000, can I continue to let my $100,000 grow in stocks while I pay back the loan? If so, this would seem an "arbitrage" opportunity if one feels relatively confident of one's ability to earn a greater than 4.25% return on capital in the 401K. Alternatively, if that $40,000 is actually debited and the balance of the 401K then becomes $60,000, this scenario doesn't make sense. So the question is whether the 401K provider is issuing a loan to you while using your 401K balance as collateral or whether you are actually issuing the loan to yourself.

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  2. Steve,

    My understanding is that you are actually removing money from the 401k and loaning that money from your 401k to yourself. You then pay back the money with interest to yourself. You aren't using the balance as collateral but instead actually removing the money. So arbitrage wouldn't work here.

    Jim

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  3. My 401k account says this about loans: "the amount you borrow comes out of your own retirement plan account, so your retirement plan balance is reduced by the amount of your loan and any related fees, if applicable."

    Jim

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  4. Dipping into one's IRA or 401(k) is like the guy who borrows from the funds he has set aside for his house payment, his rent money, or his car payment. While he has fun spending the money on a worthy cause...when he is ready to pay his house payment, the money in spent and he misses a payment. I read a helpful article at http://www.christianretirement.com about paying oneself first. I hope it helps someone else.

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