Financial experts typically suggest avoiding 401(k) loans. There are legitimate concerns about the loan slowing down the growth of the retirement plan and a potential default on the loan creating a taxable event. That said, there can be good reasons to take a 401(k) loan. So how can you know if it’s right for you?
Understand the True Cost of a 401(k) loan
When you borrow from your 401(k), you are removing a portion of your savings from the investment markets. It has been shown that missing just a few days in the market in any given year can be very detrimental to your overall investment returns. Even when you average out the investment returns and compare it to the interest you pay yourself back in the case of a 401(k) loan, you will find your hard-earned dollars leaking from the plan for years to come.
Take, for an example, someone who has a $30,000 401(k) balance, and borrows $15,000. After 5 years of paying the loan back at a 4.5% interest rate to themselves, they still end up with $1,800 less at the end of the 5 years than the person who leaves their 401(k) invested earning an average annual return of 8%. That $1,800 not being invested over 20 years would amount to over $8,000 in lost savings.
Now imagine if this same person borrows from their 401(k) two more times during their working years. Those small leaks could leave them with $25,000 fewer dollars in their nest egg. Those dollars could be used to retire months earlier or to help pay for healthcare.
Add the risk of defaulting on your 401(k) loan creating taxes and penalties, and it is easy to see why using a 401(k) loan is discouraged. If this person from the same example leaves their company, they would likely need to pay back the $15,000 or face a 10% penalty plus any taxes on the $15,000. Depending on their tax bracket, it could mean another $3,000 to $5,000 of immediate retirement savings lost. Similar to the lost investment interest, the difference balloons to tens of thousands of dollars in lost investment growth.
Review Your Alternatives
401(k) loans are borne out of the need for cash. An emergency fund is the best way to avoid a shortage or use credit cards for short term needs, as long as you can pay off the credit card balance in full. A low interest loan is also a great alternative to a 401(k) loan. If you have home equity, consider looking into a home equity line of credit. This makes a lot of sense in the case of financing home renovations.
Are you looking to pay off higher interest debt?
Consumer debt can be expensive, especially credit cards. The average credit card interest rate is 16%. With an average balance of $6,500 per card, many Americans are paying thousands of dollars in interest if they only make minimum payments.
If you just pay a little more than the minimum on a $6,500 credit card, you would end up paying $4,800 in interest over 8 years. If the interest on your debt is high (approaching double digits), the 401(k) loan can help you save money. By refinancing that same $6,500 with a 401(k) loan, that interest drops to less than $1,000 over 5 years and the loan balance is paid off in the end with the same payment.
Should you make this move to reduce your high interest debt? If you are committed to paying off your high interest rate debt for good, this can give you a cost-efficient and convenient way to do so. Just be sure that you are also committed to not using and carrying balances on your credit cards as well. Also keep in mind that 401(k) loans are generally allowed for up to five years so use a calculator to model what is a comfortable payment and only borrow what you feel you can pay back in that time frame. Once a 401(k) loan is in place, it may not be easy to adjust.
Do you need money quickly?
If you find yourself in a circumstance where you need cash quickly like a medical emergency and you lack access to low interest loans, then a 401(k) loan can help bridge the gap in a pinch. Since the loan is secured by your retirement plan balance, you are essentially functioning as your own bank. This means no credit check. Also, the loan does not show up on credit reports, therefore avoiding concerns like credit inquiries and credit utilization lowering your credit score.
If using your retirement plan is the only option, the loan is likely the best method to access those funds
When comparing a 401(k) loan with an early distribution from your 401(k), one major advantage of the loan is the fact that it is not taxed or penalized. By avoiding an immediate reduction of 20% or more of its value due to taxes and penalties, you are leaving more money invested for your future. Also, the amount borrowed is eventually due to be paid back while a 401(k) withdrawal is permanent.
Should you or shouldn’t you?
The general guidance of avoiding 401(k) loans exists for good reason. However, if you are in a circumstance where you are buried under very high interest rate debt or need funds for an emergency, it is important to understand all of your options. In the case of a retirement plan loan, take the steps of calculating the real cost of the loan and compare it with the alternatives to determine which move is the best move for you.