Should You Borrow From Your 401K?

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I’ve always said that borrowing from your 401(k) is a bad idea. However, the other day I was talking with my friend Miller when I erroneously told him that one of the reasons I thought it was a bad idea was because you paid back the loan with post-tax money even though you borrowed pre-tax money. You don’t pay back with post-tax money, you pay your loan back through payroll deductions so it’s with pre-tax money. If I was wrong on that point, I had to do more research to see if my opinion of borrowing from 401K’s was even right in the first place.

It turns out, thanks to reader Tom who confirmed this, that you pay back the loan with post-tax dollars, so my original understanding was correct. I still think 401K loans are a bad idea and the fact that you pay back with post-tax funds make it even worse.

A few things to note, while the law allows your employer to offer the 401K loan, it doesn’t require your employer too. While it’s estimated that most employers do offer it, not every single one of them does so check first before you start making plans. If your employer does, then you’ll generally be allowed to borrow up to 50% of your vested account balance up to $50,000 as long as you haven’t taken a loan in the last twelve months. If you have taken one in the last twelve months, then your max is deducted by that loan amount – basically each 12 months you can borrow up to 50% or $50k, whichever is smaller. There are a few other rules specific to your employer like the minimum loan amount (this is just to reduce the headache of paperwork) and any associated fees.

Here are the advantages of borrowing from your 401(k):

  • It’s generally really easy, no applications, no credit checks, none of the annoyances with typical loan application processes.
  • Decent interest rate, generally a point or two above the Prime rate, and that interest is paid to your own account anyway.

What are the disadvantages?

  • That interest rate is usually less than what the account could earn on its own with the money, plus you’re paying it anyway so it’s not coming from the market.
  • The loan payment taken from your paycheck might tempt you to reduce your contribution resulting in less in savings.
  • If you leave your employer, for any reason, you have to pay back the loan immediately (or within 60 days). If you can’t, it’s considered a withdrawal and you’ll owe taxes and a penalty on it.
  • The terms of the loan are set in stone and there might be some fees involved. You generally pay back the loan over 5 years, it’s more if you use it to purchase a primary residence (10-15 years).

So, should you borrow from a 401k? That depends! 🙂

{ 36 comments, please add your thoughts now! }

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36 Responses to “Should You Borrow From Your 401K?”

  1. Debbie says:

    I have a $10K loan @ 10% interest from my 401K; should I repay now via home equity LOC at lower interest rate?

  2. RE says:

    A few things;

    there are different rules when you borrow money for two purposes, a down payment on a house, and for educational expenses (such as college tuition). (No penalty for early withdrawal, in the event of non-repay.)

    In the case of my kids college tuition, 401K assets are not considered as available income in the financial aid formulas. If you save money for college, you will be penalized for having that money saved, while someone, with equal means, won’t be because they stashed that money into 401K.

  3. zoey says:

    That information is incorrect. When you borrow from your own 401k you are paying back with pre-tax dollars.

  4. Armetheus Jones says:

    I’m going through financial hardship, and i should have a problem borrowing some of my own money to help me

    • Armetheus Jones says:

      I’m going through financial hardship, and i shouldn’t have a problem borrowing some of my own money to help me

  5. Pa blo says:

    Enjoy while you can , tommorrow is not guaranteed let alone 59 plus

  6. Brad says:

    The fact that you are paying the loan back with earnings that have been taxed doesn’t seem like a disadvantage to me. I have a 401k loan and I pay it back just like I would any other loan and that is with money that I have earned that has been taxed. So that argument is nonsense to me.

    Secondly, I continue to contribute to my 401k just as I did before.

    Thirdly. The interest that I pay myself back is invested in the market and benefits me instead of some bank. Yes, I know it has been taxed but as I said before, it is taxed no matter who I borrow the money from.

    There are valid reason for not borrowing from your 401k and because of these I’d give it a long hard look before borrowing. I did find a calculator, on a bank’s web site no less that lets you run some numbers to find out how much you would lose if you borrowed from your 401k. I’m not sure what algorithm they used for their calculations but I am betting they used the worse case scenario to make borrowing from them look more attractive.

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