401k Loan

By Harper Willis

If you have to borrow money, a 401(k) may be a better option than another source like a home equity loan or credit card.

On the face of it, 401k loans can seem relatively unappealing. For starters, plan sponsors limit the amount you can borrow to 50% of your balance or $50,000—whichever is less. In addition, you have to pay back the balance of the loan within five years. And even though you’re borrowing from yourself, you have to pay interest, typically in the neighborhood of the prime rate.

But here’s the thing: that interest doesn’t cost you anything, since it ends up in your account. By contrast, if you borrow from a credit card company you might pay up to 14%–so your interest costs on a $10,000 loan could be as high as $1,400 a year. Even a home equity line of credit will cost you 6% or so at current rates, a cost of $600 on the same loan.

Borrowing from your 401k plan lets you avoid those costs, which is like earning a guaranteed return of 6% to 14%.

True, you’ll be giving up the returns you would have earned on the money if you left it in your plan. But the rate of return on guaranteed investments in 401k plans these days is pretty low—maybe 1% if you’re lucky.

Bottom line: guaranteed taxable growth of 6% to 14% beats 1% guaranteed tax-deferred growth any day.

Even so, borrowing from your 401(k) plan isn’t always the best option. Think about a different choice if:

You don’t have job security. If you lose your job and have an outstanding 401(k) loan, you’ll have to pay the loan back immediately—which could be tricky if you’re jobless. Whatever amount you don’t pay it back will be taxed as income. You’ll also pay a 10% early withdrawal penalty if you’re under age 59 1/2.

The 401(k) loan will prevent you from making the maximum contribution to your plan each year. This is an especially big drawback if you will be giving up matching contributions from your employer. In that case, it might be a better to take a longer-term loan with smaller monthly payments (maybe a home equity loan or line of credit) so you can continue making the maximum contributions to your plan.

Borrowing from your 401(k) is fairly easy, and it might be your best option in some scenarios, but that doesn’t mean you should dip into it whenever you feel like. And whatever you do, you should always pay it back—you’re going to need it later.