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401(k) loans explained
Are these easy, low-interest loans really worth the risk?
On first glance, 401(k) loans sound too good to be true: low interest, no credit check, no traditional application. That’s because sometimes it is too good to be true. Even if you’re able to pay back a 401(k) loan on schedule, you stand to lose thousands from your retirement savings — and more if you lose your job.
401(k) loan snapshot
|What it is||A loan taken from your 401(k) retirement account that you repay with interest over five years.|
|Who it’s best for||People with airtight job security who are on top of their finances.|
|Who should look for other financing||People struggling with debt or thinking of leaving their job soon.|
What’s a 401(k) loan?
A 401(k) loan is money that you borrow from your employee-sponsored retirement account, which you pay back with interest. It doesn’t require an application, your credit score doesn’t matter and interest rates are typically lower than other loans. And some 90% of 401(k) plans come with an option to borrow.
But it’s not always an ideal loan. Borrowing from your 401(k) can get expensive if you switch jobs or have trouble making repayments (we’ll get into this later). Because most people don’t have enough in their retirement savings to begin with, taking out a 401(k) loan might make things worse for you down the road.
How do 401(k) loans work?
401(k) loans are regulated by the IRS, but your loan rates and terms are ultimately determined by your employer.
Most 401(k) plans won’t allow you to borrow more than $50,000 or 50% of your account balance, whichever is less. If your account balance is less than $20,000, you could borrow up to $10,000 but you’ll have to provide collateral.
Here’s how it typically breaks down:
|Account balance||How much you can borrow|
|$15,000||$10,000 with collateral|
Some employers also set minimums on how much you can borrow — usually about $1,000.
The interest rate on most 401(k) loans is prime rate plus 1%, though your rate depends on your employer. The prime rate is what many financial institutions give to only the most creditworthy applicants, typically hovering around 3% or 4%.
Most 401(k) loans come with five-year repayment plans. An exception is mortgages: The IRS doesn’t specify how long your mortgage can extend, so your repayment term again depends on your employer.
Watch out: Your employer can restrict how you use your 401(k) loan
The IRS allows employers to limit the reasons that an employee can use to borrow against their 401(k).
If your employer does, it’s not uncommon to them limit your loan for use toward:
- Education expenses for yourself, a spouse or a child.
- Medical expenses.
- Housing expenses, including mortgages and eviction prevention.
Be sure to check with your employer first before taking any other steps.
Taking out a 401(k) loan is not as complicated as with other loans.
Start by setting up a meeting with your HR department to discuss your options. During your meeting, make sure to:
- Discuss the reason you want the loan, confirming that reason isn’t restricted by your employer.
- Review your 401(k) account and figure out how much you can borrow.
- Learn what your interest rate will be.
- If a five-year loan term doesn’t make sense for the amount you’re borrowing, ask if your employer allows for early or extended repayments.
- Ask about repayment methods. Repayments are often deducted from your paycheck after taxes.
Your employer might ask you to complete forms before receiving your funds, but it’s nothing like a typical loan application.
Why you might not want to borrow from your 401(k)
You’ll pay double taxes on your 401(k).
401(k) funds are tax-deferred, meaning you don’t pay taxes on the money you put into it until you withdraw it for retirement.
This changes if you take out a 401(k) loan. When repaying the loan, your employer deducts taxes first before withdrawing your repayment from your paycheck. And you still have to pay taxes later.
You have to repay it fast if you lose your job.
Your 401(k) is connected to your employer, so if you get laid off — or just decide to get a new job — you have two to three months to pay back your entire loan before you default.
If you default, your loan is considered an early withdrawal from your 401(k). Early withdrawals come with taxes and penalties that can add up to 25% of your balance.
You lose out on investment returns.
A 401(k) isn’t a piggy bank: You gain interest on the money you put into it. So, the less funds you have in your 401(k) balance, the less you’ll get in returns.
Even if you do repay your 401(k) loan on time, you won’t have gained as much from interest as you would have if you left your account alone.
Considering that most Americans don’t have enough saved up for retirement to begin with, making a dent can harm your financial future — and possibly your ability to retire.
You’ll likely contribute less — or not at all
While you can still contribute to your 401(k) while you’re repaying the loan, you might not have as many available funds to do so. This can cost you thousands in retirement savings. Even reducing your contributions to your 401(k) can be a costly move for your future — which you might pay for by retiring later.
You lose protection from bankruptcy.
Funds in your 401(k) are protected from bankruptcy as long as they’re still in the account. Taking out a 401(k) loan to pay off other debts you’re struggling might seem like a good idea — after all, it’s a low interest rate.
But you can find yourself in a worse financial situation if you end up filing for bankruptcy: That formerly protected money is gone forever.
Alternatives to 401(k) loans
You might want to rule out the following options before taking out a 401(k) loan:
- Secured personal loans. Putting up your car, home or other personal assets as collateral can give you similarly low interest rates with more flexible terms and significantly less risk.
- Crowdfunding. Set up a campaign on a crowdfunding platform and ask friends, family and members of your social network to make small donations toward covering your expenses.
- Borrowing from family. Another interest-free and unofficial source of financing is just asking family members to loan you money. It won’t affect your credit score, and you might not have to pay interest. Just be aware that it can seriously damage your personal relationships if you’re unable to pay it back.
- Cashing in other investments. If you have other investments, consider cashing those in first — you won’t have to pay as many taxes and penalties.
How to make the most of a 401(k) loan
Getting a 401(k) might make sense in two specific situations. The first is when you know you can repay your loan fairly quickly and are able to qualify for a short enough loan term. You’ve looked around at other options, done the math and you know that what you save in interest partially makes up for what you’re losing in retirement funds.
The second is if you’ve exhausted all of your other borrowing options, need funds and don’t want to resort to taking out a costly short-term loan.
Here’s how to make sure you don’t regret taking out the loan:
- Continue making contributions to your 401(k). You’ll lose substantially less from your 401(k) if you continue making contributions each pay period.
- Stay in your job. While you can’t always control being fired, you can control if and when you decide to quit. Avoid taking new positions until your loan is fully repaid.
- Only take out as much as you need. Figure out how much you need to borrow, and only take out that exact amount to avoid unnecessary losses on returns.
The low interest rate and easy application process might make 401(k) loans sound like an attractive option. But even those with absolute job stability and impeccable personal finances aren’t completely safe from the risks. Take caution when considering this borrowing option.
Read our guide to personal loans to learn more about other loan options to choose from.
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