No matter how much you loathe borrowing money, there are times when it’s hard to avoid loans and long-term debt. Not everyone can or wants to save up the entire purchase price of a home to live in, for example — and doing so could even be foolish if real estate prices grow as fast as you save. Maybe you need a reliable car for work and have to apply for an auto loan to afford one, or perhaps you have soul-crushing credit card debt and desperately need a consolidation loan at a lower rate.
Debt can be painful and add unneeded stress to our financial lives, but there are definitely times when borrowing can leave you better off — if you do it right.
What Is a 401(k) Loan?
Then again, there are some financial products that most people shouldn’t touch with a 10-foot pole. One loan option that tends to fall into this category is the 401(k) loan, which allows workers to borrow against their 401(k) retirement plans.
But how does a 401(k) loan work exactly? According to Lou Haverty, CFA, of Financial Analyst Insider, most employer-sponsored 401(k) plans allow you to borrow up to $50,000 or up to 50% of your vested balance, whichever happens to be less. Your total 401(k) loan amount can include your own contributed funds as well as matching employer contributions, provided all funds are vested.
Once you decide to move forward with a loan, you’ll receive the money and agree to repay it within five years with an interest rate set by your plan documents. You can also create your own repayment schedule provided it’s less than five years long.
With a 401(k) loan, you don’t pay a bank interest for the money you borrow, however; instead, you pay yourself interest. “Essentially you are substituting returns from the market for a fixed interest rate,” says Haverty.
This could be a boon for your finances or a huge downside. If the market happens to decline while you carry the loan, your 401(k) loan balance could actually benefit by earning a fixed rate rather than a negative market return. In an up market, on the other hand, your loan balance loses out by missing out on the positive market returns.
Haverty notes that the actual dollar costs for this type of loan aren’t that significant and mostly consist of administrative costs for setting up the loan. If you work for a large corporation with a big plan, these costs could even be minimal. To find out how much a 401(k) loan will cost to set up, Haverty says to check your plan documents and read through all the fine print.
So, there it is. You can take a loan from your 401(k) and use the money for anything you want. But, should you? That’s an entirely different question.
The Downsides of Taking Out a 401(k) Loan
If you can borrow against your 401(k) with low costs and pay interest to yourself instead of to a bank, why wouldn’t you? Haverty says the answer is simple — opportunity cost. A 401(k) loan can be an inexpensive borrowing option, but there is an opportunity cost that comes with removing a portion of your 401(k) balance so it isn’t growing and working for you.
We have talked at length on the importance of compound interest and how investing small sums of money can lead to huge returns over time. When you take out a 401(k) loan and remove some of the base funds from your portfolio, you’re costing yourself in terms of future returns by removing the potential for compound interest on those funds until your loan is paid off.
This loss may be partially offset since you are paying yourself back interest at a fixed rate. However, Haverty also notes how important it is to remember that, when you’re repaying your loan balance, you’re doing so with “after-tax” money — whereas you contributed to your 401(k) with pre-tax dollars. This makes the 401(k) loan even more expensive, even after you factor in opportunity cost.
But there are other reasons to avoid 401(k) loans, one of the biggest being the fact that they are tied to your employment. Haverty says that, if you happen to leave or lose your job for any reason before your loan is repaid, you’re required to pay a 10% penalty and the regular income tax for taking an early withdrawal from your 401(k) account.
If you want to avoid the penalty and taxes, you do have another option — paying off your loan in full within 60 days. While that may be feasible if you were near the end of your loan payments, it’s possible that repaying your loan in full wouldn’t be an option for many people — especially those who just lost their jobs.
In addition to these downsides, it’s also worth considering whether you’re taking out a 401(k) loan for the right reasons. If you’re borrowing against your future retirement for a nicer car, a vacation, or another item you could live without, you may have a serious problem with spending and debt. And, if you take out a 401(k) loan that ultimately prevents you from retiring when you want, you could live to regret it.
Does It Ever Make Sense to Take Out a 401(k) Loan?
With all those downsides, you may be wondering if it ever makes sense to take out this type of loan. Matt Hylland, a financial planner at Hylland Capital Management in North Liberty, Iowa, says he can think of one specific instance where it could make sense — if you’re desperate to pay off high-interest debt.
Hylland notes that many credit card interest rates surge past 20% these days (the average credit card APR is over 17%), and a 401(k) loan could be a good option if you don’t have the credit or means to qualify for a balance transfer card or debt consolidation loan.
Hylland suggests taking the time to run the numbers to see whether a 401(k) loan would make sense to pay off your high-interest debt. Your first step, he says, is putting your current credit card payment into an online calculator to determine the total cost of carrying that debt. That will tell you how much you’ll pay to service your high-interest debt for the long haul.
For example, a $10,000 balance at 22% interest would likely come with minimum payments of around $283 per month. At that rate, it would take you five years to pay off your debt and you would pay about $6,257 in interest in the end.
If you took out a 401(k) loan to pay off that entire high-interest $10,000 balance today, you would pay a lot less than $6,257 in interest during your loan period. The exact rate of your 401(k) loan will vary depending on your plan, but rates tend to be just one or two percentage points above the prime rate, currently at 5% — significantly lower than 22%. Not only that, you’ll also be paying that interest back to yourself instead of to a bank, so you will recoup those interest payments in a roundabout way.
However, you would lose some growth from your investments, notes Hylland. How much you lose depends on how long you take to pay back the loan along with the growth rate of your 401(k) investments.
With that in mind, imagine you took three years to pay back the $10,000 401(k) loan. Assuming your investments would have grown at 7% during that time, and you pay back your 401(k) loan at 5% interest, the cost of this “loan” wouldn’t be too significant. “The lost earnings on your 401(k) investments is bad, but not nearly as bad as credit card interest payments,” says Hylland.
Rob Drury, executive director of the Association of Christian Financial Advisors, says there’s another time it could make sense to take out a 401(k) loan — when you’re buying a home.
According to Drury, the five-year repayment requirement may be waived if you use your 401(k) loan proceeds to purchase a home. And because you’re borrowing your own money, there’s no credit check, either. This could make a 401(k) loan an attractive option for securing a down payment for a home — but again, you have to keep in mind that you’re borrowing from your retirement — from your future — for this. If you could come up with a down payment for a home another way, you would likely be better off.
Haverty says that the best way to use a 401(k) loan to buy a home is if you need the loan proceeds for a very short period of time, such as closing a new home before your current home sells. In this case, a 401(k) loan could give you access to liquid cash for a limited time, but you could pay it off quickly once your home sells. Or maybe you’re expecting a huge bonus at work at the end of the year and plan to use it as a down payment. With a 401(k) loan, you could borrow that amount now to buy a home then use your workplace bonus to pay off the loan once you receive it.
While there are a few scenarios where a 401(k) loan does make sense, all the experts we spoke to said this type of loan isn’t a great deal the vast majority of the time. This is partly because you have to repay the loan with after-tax dollars, but it’s also because you’re losing out on compounding growth and benefits from keeping your money invested within your 401(k).
This type of loan also rarely makes sense for workers in unstable jobs or industries experiencing a downturn, since 401(k) loans can become hazardous if you leave your job. Remember that, if your employment is terminated or you leave your job for any reason before your 401(k) loan is repaid, you’ll either have to repay the loan balance in 60 days in most cases or pay taxes and penalties on your outstanding loan balance.
Should you get a 401(k) loan? The choice is yours, but there are plenty of ways to borrow money that come with less risk and fewer downsides. And maybe, just maybe, you don’t need to borrow money at all. Before you decide, make sure to think about what you really want — and what you actually need.
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