Devil's Advocate 

Borrowing From Your 401(k)

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This is a Devil's Advocate post.

One of the oft-discussed cardinal sins in personal finance is to borrow from your 401(k), 403(b), or other eligible retirement accounts. The reasons against borrowing are obvious – those assets are for you to consume in retirement, not right now. By borrowing those funds, they can’t grow with the market tax free and you lose one of the great vehicles for retirement planning.

Not everyone can borrow from their 401(k) or 403(b), the plan administrator has to permit it, but this Devil’s Advocate post will discuss reasons why this may make sense for the limited number of employees who can borrow from their 401(k) plan.

You Have a Weak Credit Score

The number one reason why it would be a good idea to consider borrowing from your 401(k) is if you have a weak credit score. With loan standards at their highest in recent memory, borrowers with less than good credit may find themselves unable to secure a loan in the first place. If you’re buying a house or a car, lenders may require you to come up with a much larger down payment and you could bridge that gap with a loan from your 401(k).

When you request a loan, there is no credit check, which can weaken your score even more.

Better Interest Rates

By borrowing from your 401(k), you can guarantee yourself a loan and an interest rate that beats whatever you’d get out in the market. Even if you have a great credit score, a 401(k)’s interest rate will likely be lower than any rate you could get on a non-primary residence mortgage loan. You can call your plan administrator and find out what the prevailing interest rate is and compare it with quotes you get elsewhere to know for sure.

In general, the interest rate will be the prime rate plus 1%. The current WSJ Prime Rate is 3.25% so your standard 401(k) loan interest rate would be 4.25%. You can’t get a 30 year fixed rate loan for 4.25% right now even if you have a stellar credit score and put down 20%.

Regimented Repayment

When you borrow from your 401(k), you’ll need to repay the loan over the course of five years (longer if it’s for a home) and those payments are automatically deducted from your paycheck. There isn’t another bill to pay and there’s no way for you to “forget” to mail it in. The payment is deducted directly from your paycheck.

Lastly, borrowing from yourself is more convenient. There are no long application forms and no fears of rejection. You pay yourself interest, which is tax sheltered until you start taking reimbursements in retirement, and the payments themselves are automatically deducted. Many pundits make this issue seem like the worst of the worst in money ideas but in reality it’s not as tragic as they make it out to be.

There’s no question that borrowing from your 401(k) is not ideal. The opportunity costs are enormous. However, many families are going through very difficult financial times and this may be a viable option for them. A fat retirement account is meaningless when you’ve been out of work for months and you have mouths to feed.

Would you ever borrow from your 401(k) or 403(b)? Have you done so already? Any lessons or warnings?

{ 30 comments, please add your thoughts now! }

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30 Responses to “Borrowing From Your 401(k)”

  1. Simon says:

    There is a mistake in the article. You can’t borrow if you don’t have a job plus if you do borrow and you then lose your job or even leave of your own accord the loan is immediately due. If you default the it’s a withdrawal subject to a 10% penalty and you can never get that money back in your 401k. People need to be careful because these are the downsides not well pointed out in this article.

    • Jim says:

      Excellent points Simon, this article was designed to highlight the positives rather than point out the negatives. It is, by design, supposed to be a little one sided. That said, your points are accurate and correct and, in general, I do not think it’s a good idea to borrow from your retirement funds.

      • Jesse says:

        I had the exact same thought as Simon when I read this article. While I see that this was designed to be a one sided article, I fear that someone stumbling across it might get the very wrong impression.

    • skylog says:

      good point. i had to more or less beg a co-worker to either believe me or research it for himself with regard to having the loan come due if he lost his job.

      • t says:

        The loan is NOT due upon losing, changing, jobs UNLESS the company at which you work requires it to be. I have utilized this option in the past. You cannot remove the remaining funds from the 401K, or roll them over until the loan is paid off though.

  2. John says:

    So, when you barrow from your 401k, does the loan then take the amount out of 401k? Meaning, the balance of your 401k drop because of the loan, thus reduces retirement earning potential?

  3. Bey says:

    It’s a poor idea — and I say that even after having done it. I was disciplined and paid my loan off early. Don’t forget that A) you’re paying back the loan from your tax-deferred account with funds that have been taxed, and B) those funds had the potential to earn more in the market than the interest you’re paying yourself. Remember too that if you lose your job, the balance of the loan becomes due and payable. If you can’t cough up the lump sum that’s due when this happens, you’re on the hook for taxes and penalties.

  4. Jason Ronis says:

    I’ve advised someone to borrow from their 401k once. They had an opportunity to drop 3% by refinancing their home mortgage (at 500k the savings were quite meaningful). To do so they needed enough money to pay off a second mortgage… It made sense for them, and the saved interest allows / allowed them to pay back the 401k quite quickly.

  5. Strebkr says:

    I guess its probably a good idea for a few people, but for the vast majority, there is probably a better option.

  6. David M says:

    Strebkr – I agree with you 100%!!!

    Good for very few people.

    American listen up – if you can not afford it, without borrowing from your 401K – then do not do it!

    It amazes me, how financially illiterate the vast majority of American are. Retirement money is for RETIREMENT!!!!!!!!!!

    • NateUVM says:

      This comment speaks to how important education is. Ensuring the education of our children, peers, etc… is the one true panacea that can help this country, world along. Should be made a priority of national signifigance.

      Which is why I am saddened by all these recent attacks on teachers and the salaries they receive. IMHO, they should be rewarded the MOST by our society, based on the importance/difficulty of the job they do. If people are unhappy with the current performance of teachers, perhaps higher salaries would attract the kind of teaching talent that would provide higher education returns.

      Sorry for going so far off-topic. Just an issue that’s been bugging me lately.

      • Strebkr says:

        I agree that education is the key. And I agree you have to pay for good educators. What I don’t agree with is the current pay structure. You get raises based on how long you have been there, blah blah. I want to see a performance driven system like we have in the private sector. Make them earn it like the rest of us. There are plenty of great teachers out there who will do just fine with this new system.

        • NateUVM says:

          I agree with rewarding top performers and not just crediting tenure, for instance. The problem is HOW do you measure that performance? Sometimes the best teachers, because of their abilities, are given the most challenging students/situations to deal with… Would it be fair to those teachers to merely use the test scores of their students as a means to rate them?

          Very difficult issue with LOTS of emotion built into the debate, from both sides.

          My comment, however, was more geared towards the general debate where teachers appear not to be valued for the work they are doing. I.e. suggesting that the don’t earn their salaries because they are on vacation three months of the year, etc… We need to stop throwing stones and to start valuing what teachers mean for our society.

          For my money, I rationalize that their salaries are already pro-rated around their summers being off and that they are getting paid for the time they work…because they ARE that valuable. Nevermind that plenty still have to pick up jobs over the summer to make ends meet.

        • Silver says:

          Actually, I am a teacher and it DOES NOT work like that. The teachers in my district have not received a pay increase in 4 years. The last increase was 30 bucks a month. Did I mention teachers still have families, car notes, and mortgages?

  7. Shirley says:

    I did borrow from my 401k back in 1991 and paid it back very quickly. The downsides were not as clearly explained as they have been here.

    It was for a oarty for my folks’ 50th anniversary and I didn’t feel as if I had a choice at the time, but now I realize there definitely were other choices.

  8. billsnider says:

    I know of two people who borrowed and both regreted it later.

    Not a smart idea unless you really have a very, very, very,very, very good reason to do so.

    Bill snider

  9. Tim says:

    If you are paying off your 401k loan with after tax dollars , then what are you paying off a non 401k loan with ?
    After tax DOLLARS !!
    That is the weakest reason that is stated, I believe , they are the same dollars.

    • Shirley says:

      I believe the point was that the money you are borrowing from your 401k is dollars that were put there before they were taxed, and they will therefore be taxed when you retire and/or they become distributions.

      The dollars you are repaying with have been taxed already, but will be taxed again with the rest of the money. Hence, you will be taxed twice on money used to repay a 401k loan.

      • Bey says:

        Thank you Shirley, this is a point many people miss when discussing the topic, and I certainly didn’t make it very clear in my previous post.

        I borrowed in order to make a larger downpayment, and therefore get a better interest rate, when I bought my house. But I was also aware that the repayment of the loan was going to eat away at advantage I’d gained if I didn’t pay it off quickly.

      • NateUVM says:

        Re: Double Taxation… This isn’t exactly true, Shirley…

        You’re not taxed on the proceeds of the loan, and, when you pay the loan back, from the IRS point of view, you are just putting the same, pre-tax money back into the account. That’s why it’s still taxed when you ultimately take it out of your 401(k). It’s also why you owe taxes if you don’t end up paying back the loan.

        That the funds you are paying the loan back with were already taxed is, in this case, irrelevent.

  10. zapeta says:

    It’s nice to see a post highlighting the potential upside from borrowing from your 401k. However, I agree with most of the posters here who think its a bad idea.

    • Jim says:

      Sometimes it’s a useful exercise to see the other side of an issue, which is the point of these Devil’s Advocate posts. 🙂

    • NateUVM says:

      Everyone’s situation is different and, for some, borrowing against their 401(k) can be a reasonable option. Not for everybody, for sure. But, like any investment decision, there’s a population for which it is a good idea, and a population for which there is no real benefit (or, possible detriment).

  11. JoeTaxpayer says:

    Opportunity costs – Say I have an 8% mortgage that’s upside down. The amount I need to refinance is $200K and I need to borrow $20K to make this happen. My current 401(k) loan rate is 3%. The savings to go to 5% on that mortgage is $6K/yr at the start. So, simply put, the $600 interest to my 401(k) over the first year has enabled me to save $6000.
    a – I am $5400 to the good in yr one
    b – my 401(k) is better off as my bond fund yield is below 3%.
    c – the benefit to me is so high that even if I lost my job, the refi puts me in a far better cash flow situation.
    d – in year 6 after 401 loan is paid, I use the extra funds to accelerate the mortgage.

    This is the rosy scenario to be sure, but it does exist and while I know some will disagree, the facts are contrived to make it ideal.

  12. Robert says:

    I have to agree with this post, Being able to take a loan against my 401K for my home purchase was fantastic since it let me get my home during the housing slump vs. having to wait a few more years. I paid it off quickly (house and loan!) and then a year later did the same thing to invest in my own new business that is doing well.I say use your 401k money if you need it instead of letting it sit there if there are good opportunities that will only be available for a short time. A truely wealthy retirement at a young age will only be achieved by what businesses and opportunities a person develops before they get too old to work. Depending on your industry that retirement age is different…How many 65+ construction workers do you see? some jobs wear you out by age 50.. and what’s the point of being the richest person in the nursing home after having lived a drab scrimping life? The age limit for 401k withdraws is ridiculous anyway in my book.

  13. tim says:

    The loan I took in 2007 was pretty good in that the opportunity cost of that loan was NOT losing 30% over the next few years in the markets.

  14. skylog says:

    i can see reasons why a person would, as well as why it may work out for that person; however, i still think this is generally a very bad idea for most people.

  15. Lavern says:

    I have to agree with Robert. What good is it to be a rich person in a nursing home. I also agree that a person should be able to withdraw their own money soon then 59 1/2 years old without penalities. I’ve spoken with quite a few people who plan on retiring at age 55 years old while they can hopefully really enjoy their retirement, hence this is the age that I think that persons should be able to withdraw or roll over their money without facing any penalities.
    Also if a person decides to borrow it’s important to look at the reason as some stated above…good reasons could be for home purchase or opening your own thriving business and setting up a plan to pay them off earlier then say 5 years and/or creating an extra savings plan that you will not touch in case your situation changes to help you to pay off the loan.

  16. Josh says:

    I have taken out several loans against my 401k in the last few years. My credit was bad(325)at the time and I was closing out several credit cards that had already gone 30 days past due. I had already cut up the cards and used the money for the non recurring pay offs and to catch up on recurring bills (car, rent, utilities) all to help clean up my credit score, now I am almost back in good credit standing (650). The one thing to remember is to plan ahead knowing that your paychecks will be slightly lower until the loan is paid off, and cut costs where you can. You always want to do better then breaking even.

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