Even though I’m in a much better place financially than I once was, from time to time I ponder how and where I would obtain funds if I absolutely needed to. Credit cards? Personal loans? What about borrowing from yourself in the form of a 401(k) loan? While that last option might be the most attractive of the bunch, there are still some downsides to borrowing from your 401(k), as I know first hand.
Here’s a quick look at how 401(k)s work, why they may seem like a good idea, and why they might not be:
How 401(k) loans work
Before I get into the pros and cons, I should probably explain how borrowing from your 401(k) even works. As you contribute to your retirement account you’ll build up what are known as vested funds. This refers both to the money you’ve put into the account as well as any employer matching funds that you’ve earned. However keep in mind that your total balance may not be the same as your vested balance — many employers require you to stay with the company for a set length of time before you’re able to keep any matching contributions or profit sharing.
In most cases you’ll be able to borrow against what you have vested up to a certain threshold. Often times you’ll also be able to set the loan’s term length, meaning how long you have to repay it. Once you’ve done that and officially request your loan you’ll receive a check for the sum you’ve selected. Since 401(k)s are funded through your employer, the majority of 401(k) loans are repaid by deductions made to your subsequent paychecks until you’re all paid up. Also note that your regular contributions will continue while you’re still paying your loan back.
What’s appealing about them
Admittedly there are plenty of things to like about 401(k) loans. First, since you’re essentially borrowing from yourself, the interest rates are relatively low. I remember when I took out $1,000 for my first trip to Tokyo, my six-month loan was only going to cost me $8 in interest. Additionally there’s often a fair bit of flexibility available when it comes to setting your loan terms, allowing you to borrow in a way that makes sense for your budget.
For these reasons as well as the added convenience of payments automatically coming out of your paychecks it’s easy to understand why this option ranks above other more expensive or embarrassing (e.g. borrowing from friends of family) ways of obtaining money. However it turns out that your seemingly simple loan can come back to haunt you down the road.
The downside of borrowing from your 401(k)
As I mentioned, lured in by the low interest rate of the loan and following the advice of a fellow manager at work, I ended up borrowing $1,000 from my 401(k) back in 2010. Unfortunately for me I decided to quit my job only a few months later. The problem is that I was required to pay back the remaining balance of my loan immediately — not a great prospect when you’re leaving your salaried job for the unknown — or it would be counted as a withdrawal. What does that mean? Well for me it meant that, in addition to having to pay taxes on the money I took out, I was also assessed a 10% penalty since I was just little shy of retirement age. Suddenly that cheap loan was getting expensive.
Even if you have no intention of leaving your position and ending up in the same predicament I found myself in, there’s another aspect of borrowing from your 401(k) that may go overlooked and could cost you more than you realize. When you take money out of your retirement account you’re also putting a halt to its growth. As a result you could be hurting your overall returns — especially if you borrow a large amount for a long period of time.
Calculating just how much profit you’re risking by lending yourself cash from your account can be difficult, which is why most people probably don’t bother to consider it. Luckily Bankrate offers a 401(k) loan calculator for this very purpose. With that in mind it’s definitely worth running the numbers before you decide if borrowing from your retirement is really such a good idea.
To be honest my biggest financial mistake actually wasn’t borrowing from my 401(k); it was failing to repay the loan when I quit and then taking out extra money with it. In fact I might still consider the option again if we (God forbid) needed to. That said I now understand that there’s a lot more to such loans than I thought half a decade ago. Ultimately, if you’re in need of a loan, be sure to avoid my mistakes and take everything into account before pulling the trigger.