What You Should Know Before You Borrow from your 401k

3 min read

401k loan

Taking a loan from your 401k can be a super low-cost way of getting funds when you urgently need them! Unlike getting a personal loan or using your credit card, the ability to borrow from your 401k is much simpler!

Essentially, it was coined with the term “borrowing from yourself” since all interest and payments are made back into your 401k.

Although it’s relatively simple to get a loan from your 401k, there are certain rules and disadvantages you need to know before doing so!

How much can you borrow?

As awesome as it would be to borrow your entire 401k balance, there are limits to how much you can actually borrow.

The maximum amount you can borrow is typically 50% of your vested account balance. So for example, if you have $30,000 vested in your 401k, you can only borrow up to $15,000. Other retirement plans can have different limits and depending on your employer, can also have restrictions on when you can actually take out a loan.

When does the loan have to be repaid?

Once a loan has been taken out, your repayment will be through payroll deductions. So basically, the payment is taken directly out of your paycheck. Typically, 401k loans should be paid back within 5 years. There may be some exceptions with the repayment period, so make sure you ask your employer first.

Interest payments

Just like any loan, no money you borrow is free (even if you borrow from yourself). The interest rate on your loan is typically determined by the plan administrator and the current economic prime rate. This interest is paid to yourself since you’re essentially borrowing from yourself.

Advantages of taking a 401k loan

Here are the top 3 reasons to look into taking a 401k loan:

1. Easy to qualify for the loan

Unlike a traditional loan from a bank, getting a 401k loan can be quick and easy without requiring credit checks, employment history, and any of that long red tape.

It can be as easy as a few clicks and have the loan funded into your account in a matter of a few days.

2. Low cost

Other than the origination cost and admin fees that may apply, it won’t cost you much to get a loan. Unlike banks that ensure they make a profit first, the fees you pay may end up being high.

Whereas, getting a 401k loan from your own 401k balance, the fees are very minimal, thus saving you some extra cash in the end.

3. Interest is a good thing

Just like any loan, when you borrow from your 401k, there is an interest payment added to your repayment. However, the cool thing is, that you’re basically paying the interest to yourself!

A potential perk to this is that if you borrow from your 401k during an economic downturn, your retirement could actually benefit even further from the interest you are paying yourself as opposed to the losses you would’ve incurred instead.

Disadvantages of a 401k loan

Alright, now we have to look at the top 3 disadvantages of a 401k loan:

1. You can’t change jobs

Here’s the biggest caveat of taking out a 401k loan. If you leave your employer and have a balance on your loan, the entire balance will become due!

That means, if you borrow $15,000 from your 401k and pay it down to $12,000, the entire $12,000 becomes due once you leave your employer. If you fail to pay it, you will pay income tax and a hefty penalty. Something to seriously consider.

2. Missing out on employer-matched contributions

If your employer offers contribution matching, you will also miss out during that time you are repaying your loan. Loan repayments are not considered 401k contributions, so no payments that you make will be matched by your employer.

3. Missing out on growing your retirement

Another important thing to think about is missing out on growing your 401k. According to Fidelity, the average 401k balance is $13,200 and the Median is $5,000. A far cry from what one would need to retire. Retirement planning is an important thing to really think about.

When you take a loan out of your 401k, the funds you are using are missing out on the potential interest it would earn and basically robbing your future self. This is less of an issue the younger you are, and more of a concern the older you get.

Final thoughts

There are strong arguments that can be made regarding 401k loans (whether they are a good or bad idea). Ultimately it will depend on the individual and their situation.

It is good to consider if:

  • Funding emergency expenses
  • Cannot qualify for any other kind of financing
  • If you are young and have enough to catch up
  • If it’s a small amount

However, it might also be a bad idea if

  • You’re nearing retirement
  • If it’s not an urgent expense
  • If it’s a substantial chunk of your 401k balance
  • If you haven’t exhausted every other option

These are just a few things to consider but ultimately, it all depends on your retirement goals and other savings you might have 🙂

Remember to just be responsible and take your retirement top of mind.

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