Let’s say you find yourself in need of cash, and a loan is the only way you’ll be able to come up with it. You’ve got a decent nest egg building in your 401(k) … wouldn’t it make more sense to borrow from that 401(k) and pay back the principal and interest to yourself instead of a bank making money off your loan?
In a word, no. Borrowing from your 401(k) is very rarely a good idea. Many retirement plans don’t even allow you to borrow from your retirement plan. It’s not uncommon for people to do it when it’s allowed; about one-third of 401(k) participants have borrowed from their plan, but 44% of them regret it.
There are two main reasons we recommend against borrowing from your 401(k): It hurts your retirement savings and it’s very risky.
Don't Hurt Your Retirement
The most powerful tool you have as you save for retirement is time. Compounding interest is the secret ingredient that puts time to work for your 401(k). The earlier you start saving for retirement, the more time your money has to grow, and just a few years difference can have a huge impact on your final retirement savings.
Taking money out of your account for a few years because you’ve borrowed it can also have a significant impact. Some plans don’t allow you to continue to contribute to your 401(k) while you repay the loan. Even if you are able to keep up your contributions, the money you’ve borrowed won’t earn as much interest from being loaned out to you as it would in a healthy investment market. Even worse, if you default on the loan and that money never makes it back into your 401(k), the damage could leave you far short of what you need to retire comfortably.
It's a Risky Situation
We just talked about the risk of the money not making it back into your retirement if you default, but that’s not the only scary part of borrowing from your 401(k). You can borrow up to $50,000 (but not more than half your balance or $10,000, whichever is higher) with a maximum repayment term of just five years (with the exception of loans made to purchase a home).
Whatever your loan term, it shrinks dramatically if you leave your current employer (either by choosing to leave for a new job or losing your job), typically becoming due within 60 days, though the specifics vary by plan. Imagine being stuck in a job that’s making you unhappy but not being able to leave because you can’t afford to pay back your loan, or the double whammy of losing your job and now owing the balance of the loan.
So, what happens if you default? If you can’t pay back your loan, it turns into a distribution. That means the money won’t go back into your 401(k), you pay income taxes on it, and, if you’re under 59 ½ years old, you get hit with a 10% early withdrawal penalty. Ouch. There is a grace period that gives you a little more time—until your individual tax return filing deadline—to repay the money but depending on the amount you have left to pay back, it may not be enough time.
What are the Other Options?
Your retirement fund isn’t money you want to gamble with and borrowing from it is risky at best. A personal loan or home equity loan is a better fit for the most common reasons people borrow from their 401(k)s: down payment for a house, child’s wedding, debt consolidation, home improvements, and medical expenses.
A home equity loan will allow you to deduct interest payments when you file your taxes, but only if the funds were used to increase the value of your home. Consult a tax professional before making a decision about a loan based on interest deductibility. Otherwise, the differences mostly come down to whether short-term debt (personal loan) or long-term debt (home equity loan) are a more appropriate fit for the expense. We dug into the difference in this post: How to Decide Between a Home Equity or Personal Loan.
About Janet Weinhofer
Jan is the VP of Lending at GOLD. She directs and coordinates all lending activities within the credit union, ensuring compliance with lending policies. She ensures her team provides friendly, professional, timely, and personal service to all our Members. Jan is proud to be part of GOLD’s mission to empower our Members to achieve personal financial success.
Better Borrowing - November 11, 2019
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