Short-sighted. Impulsive. Terrible idea. Robbing your own retirement. These are just some of the things you will hear in the financial media when it comes to borrowing money from your 401(k) plan. How much of this is reality and how much is myth? We are going to explore how 401(k) loans really work and when they could be a good idea – or the worst plan ever.
How 401(k) Loans Work
Unlike traditional loans, borrowing from your 401(k) is not a true loan in the sense that there is no lender involved and your credit score is not a consideration. More accurately, they represent the ability to access part of your own retirement plan money, which must then be repaid to restore your 401(k) plan to approximately its original state.
You pay the interest on the balance of a 401(k) loan is back into the account. As a result, the impact on your retirement savings can be minimal – and in many cases it will be less than the cost of paying interest on a bank or consumer loan.
- Quick & Easy: Typically, requesting a loan inside most plans is simple. Most plans do not require long applications or credit checks, which means there is no credit inquiry impacting your credit score. A growing number also allow participants to make their request online.
- Flexible Repayment Options: The majority of plans allow accelerated repayment or prepayment with no penalty. Often you can set up the repayment to happen directly through your company’s payroll withholding.
- Low Fees: While there can be loan origination costs or maintenance fees, these fees are relatively nominal compared to most conventional lending sources, which can come with big application fees or origination fees.
- Help (or at Least Don’t Hinder) Your Retirement: Payments are usually allocated back to the investments you borrowed from or chose to apply them to. This means the interest you are paying yourself will be added to your investments. There is no definitive loss of investment earnings either. If the investments would have increased in value, then yes, you miss out on those investment gains; but the flip side is also true. If the market goes down, then you miss out on any losses as well. Most of the strongest critics of 401(k) loans tend to assume that the market only goes up when they make their arguments, and we all know this isn’t true.
- Pay Yourself Not the Bank: Yes, you are paying interest on the loan; however, you are paying yourself the interest. Interest paid on consumer debt such as credit cards comes at much higher interest rates and goes in someone else’s pocket.
401(k) loans are not all peaches and cream. There are some serious disadvantages, including:
- If you are terminated or quit, you have to pay back the full loan in a lump sum or it is a deemed distribution. This means you’ll have to pay taxes and likely a 10 percent penalty on the remaining loan balance. This can be negated by qualifying for a hardship withdrawal or paying the loan back within the grace period, typically 60 to 90 days.
- If you are borrowing the money because you are in financial trouble, you need to make sure you budget for a lower future paycheck as it is paid back.
- If the investments you borrowed against do produce stellar returns, you will have forever missed out on those gains and the potential compounding.
401(k) loans are not always a bad idea. Under the right circumstances, they can provide a simple, convenient and lowest-cost borrowing option. Yes, they have potential disadvantages, but so do all loans if they are taken irresponsibly or at inopportune times.