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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! :)

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

  1. Disadvantage #3 is the reason most employers allow you to borrow against you 401k. It makes it very difficult for someone to leave the company they work for. Overall this is not a great option for borrowing money. I would only use it in emergency situations.

    • Biffton Ulysses Yuppie says:

      Borrow from 401K?
      100% of my 401k is in government bonds and I am the only one in my company who has not seen a loss in the past few years. The biggest looser lost over 50% of their portfolio.

      If I borrow $5,000.00 at 5% and pay off 18% credit cards, I have a net gain on 13% over time. Or is my math wrong?
      BUY

      • jman says:

        you actually have to take into consideration the return you would have made on that $5000 you borrowed. you could break even or maybe even lose money on the deal.

  2. I always thought that even though the payment is deducted from your paycheck, it is still paid from post-tax money.

  3. Tom says:

    I agree with Single Guy. I have a 401(k) loan. I did it because it was cheaper and easier than a bridge loan when we bought our new house. My deductions are most definitely post-tax.

  4. jim says:

    Wow, I guess I was right the first time… weird. Thanks for the clarity.

  5. Jeremy says:

    Just because the loan repayment is done via payroll deduction doesn’t mean it is a pre-tax payment. Loan repayments are still done on an after-tax basis.

  6. Jeremy says:

    Oops, I’m slow to respond. I see you have already edited the post.

  7. dong says:

    I borrowed a small amount from 401k years ago when I was buying my condo. While not ideal, it was best option I had the time. I just needed enough to get my downpayment to the 10% level so I could piggyback a 2nd mortgage avoid PMI and still get a good rate. Also it’s somewhat misleading to characterize the payments just as post tax because the money you’ve received in the form of the loan is pretax.

    So for example, let’s say you have 1000 in your 401k, and borrow 1000 at 5% interest. When you take that loan you haven’t paid taxes, so you could then just pay back the loan with the $1000 you took out plus $50 in interest. The interest portion is coming from after tax dollars but the principal is basically what you borrowed which was not taxed. Given that the interest is being paid to yourself, it’s not such a bad deal.

    In general I agree borrowing from your 401k, but like anything else in life, sometimes there’s a time and place for it.

  8. MoneyNing says:

    Without reading the article, the answer is NO :) Once you try to read the details, it will always be a “maybe”. If you take money out, it can’t grow tax deferred.

  9. wealthy_1 says:

    We borrowed from our 401K once to pay off credit card and other debt. My husband got laid off and the 401K loan became income. At tax time we owed Uncle Sam $13,000!

  10. Howard says:

    A couple of things you may not be clear on and a comment. The comment first. The cost of borrowing is simply a factor, if the gain from borrowing is greater, then deploy the capital as needed. The real task is to increase your net worth. To clarify, the terms of a 401k are not exactly set in stone. You can repay it early, you can also partially repay it and reamortize it. As you kind of mentioned you can also increase the loan (or take another) up to the max. Finally if you need to make the psycological argument, if you consider it a fixed income portion of a diversified well allocated portfolio, the yield is better and hopefully you trust yourself to pay yourself interest more than anyone else.

  11. Jeff says:

    Suppose you have 100K in your 401(k) plan. That means you are earning interest on that amount and of course it’s compounded over time. If you reduce that amount by 50K becasue you wanted a loan, you will have reduced your nest egg by half. Even though you agree to pay it back over XX number of years, you will do so on a monlthly basis through payroll deduction and I don’t see how you will ever make up what you will have lost over time in compound interest. It seems mathematically impossible.

  12. Jane says:

    I have borrowed from 401k to pay off debt. Considering that we closed the accounts and paid them off with a loan at 5% and they were charging 18% & more, I feel it was a good decision. You have to pay it back in 5 years. How many of you have ever paid off your credit cards in 5 years at 5%??

  13. Jeff says:

    I see your point Jane! That’s really something to think about.

  14. Anonymoooose says:

    This whole post-tax, pre-tax thing is very misleading and it is not as cut and dry as some like to make out. An example might be best to help illustrate the situation.

    Imagine you had contributed $10,000 to your 401K. The money is pre-tax. For arguments sake, let’s say you’re in a 25% tax bracket. This means if you had NOT contributed to the 401K, you would have $7,500 in your pocket (after tax money). So, a $10,000 contribution COSTS you (in pocket money) $7,500.

    So, you can borrow 50% of that, therefore you’re able to borrow $5,000. Don’t forget you’re borrowing PRE tax money. If you felt like it you could keep that money in the bank – so you’ve got this pre-tax money sitting in a location usually reserved for post-tax money. Let’s imagine you just sit on the cash…

    Your monthly payment is made up of principal and interest. The principal is essentially paid by PRE tax money, as we’ll take it from the pile of money we withdrew. The interest does, however, have to come from other money sources (excluding taxable interest you earned from your pre-tax loan money). So really, the only POST tax money you’re using to pay back this loan is the interest that you have to pay back to yourself, excluding the interest your bank gave you for the PRE-tax money.

    Obviously, this example is a little odd because putting the money in the bank is a silly way to lose money compared with leaving it in similar investments in your 401K. But it does illustrate the pointless of this pre-tax, post-tax debate. If I could pay back a loan with pre-tax money, I’d be borrowing all the time! I’d stick the pre-tax loan in my bank account and then fill my 401K back up with pre-tax money! Obviously, not gonna happen…

    Really, the questions is: what do you intend to do with this money you’re going to borrow? It had better be a darn good reason, otherwise it’s just not a wise decision. In essence, you need to fulfill two tests:

    1) Darn good reason.
    2) Ability to pay back quickly if you leave your job, or willingness to take the tax and penalty hit on your account.

    Usually, if you have the ability to pay back the amount, then you wouldn’t need the loan in the first place. Often it comes down to a balance of risks. i.e. paying back the credit cards with the loan is go great a solution that it outweighs the risk of losing the job and having to take the loan as a distribution (you don’t need to come up with the cash).

  15. Bonnie says:

    I think it is irrelevant to the decision that the pay-back of a 401(k) loan is with post-tax money. All loans are paid back with post-tax money so – as to that factor only – borrowing from the 401(k) is no better or worse than borrowing from any other source.
    I think some of the negatives consider the choice as between borrowing or not borrowing. The question has to be examined as if the decision is to borrow from the bank or your 401(k).
    In my view, the main downside is that the interest rate (that you pay to the 401(k)) is less than what the money would earn if left alone. That difference has to be compared however to the cost of borrowing from another source. Losing 1 or 2 percent of return might be outweighed by the higher percentage you would have to pay the bank or credit card company – as Jane made clear.

  16. ron blan says:

    What if for some reason the company went bankrupt and robbed your 401k money like we read about in the papers. Say you had a pretty good nest egg and borrowed from the 401k to pay off the loans on your property. Would a person be better off in that situatuion than to have the loans through a bank or some other financial institution. The way I look at it, if the money was stolen from your 401k savings, you at least would have your homeplace paid for. What could they do, make you pay it back so they can steal more?

    • LaMoor says:

      Because I believe there is going to be a total meltdown in the US borrowing from 401 K and reducing the income you put in it is a good idea. If you are required to pay it back keep the money you borrowed and pay back the interest before tax time. I agree with Ron if Wall Street keeps stealing the money why do we keep putting it in the market. I believe it is a temptation to weak people who see our funds as easy prey to satisfy their addiction and the worst part of this they are not required to pay it back nor does anyone go to jail.

  17. Robert says:

    Just one thing. I have always thought that borrowing from the 401k was a good idea. Depending on the circumstances. I borrowed 3k in ’99 just in case of a computer meltdown, so I would have cash on hand. Welll, as we all know that market took a dive in ’00-’01, but I was paying myself back @ 8% while the market was taking up to 30% off my 401k investments. So I was buying back in at reduced prices, since the market was going down. I don’t think it would be a good idea to try & time the markets that way, but it worked out for me, since I was able to pay it all back in two years, at a reduced price on shares. This part about not making as much on your pay back as you would get from the investments does not work in a recession.

    I would do it again, in a down market. Maybe 2008?

  18. Panks says:

    I agree with Robert 100 %, actually my research of a probable recession in 2008 lead me to this articile and if the recession indeed comes and market takes a nosedive , I think loaning from 401K and investing in recession proof equities/markets would definitely be a lot better choice.

  19. G says:

    Question: I borrowed from my 401 K to pay off credit card debt and purchase furniture for my new apt. It was around 5,000. The APR is at 10%, it seems that I my finance charge is only 286.00 and I have 26 payments of 200.00 bi-monthly payments to pay it off. I think thats a pretty good deal, would anyone disagree?

    please respond.

    ~G

  20. Eric says:

    I have a unique situation where it seems to be totally favorable to take a 401(k) loan:
    My company is relocating me. As a result, I am selling my home and buying a new home. This would be cut-and-dry if I would sell my house first, and then buy a new home. Complicating matters is that I have 2 young children and keeping my home in show condition is something I would prefer not to do.
    Now, I plan on buying a new home and moving into it and putting my house on the market at the same time. My company will give me an interest-free advance of about 50% of the equity I have in my home. They will also pay my mortgage while I have two payments and promise to buy my home after 120 days.
    In this case, I need about $20,000 cash to keep my LTV below 80% on my new home. The maximum time period I will need this loan is 120 days. I will not quit my job, and getting fired is highly unlikely (my company would not relocate me if that were the case). I will repay the loan once my first home sells and I capture the equity.
    The $20K can come from either a bridge loan or my 401(k). My 401(k) charges $25 and about $3 per month in fees. My worst-case scenario on fees is $37. A bridge loan, on the other hand, is several hundred dollars in closing costs plus a healthy interest rate that goes to the bank. With the 401(k) loan, I recapture the interest during retirement.
    If the stock market takes a sudden up-turn during the 120 days that I have the loan, then I lose out on growth. With the market as it stands now, I would argue that I have at least an equal chance of the market tanking. If the market is lower when I re-pay my loan, then I have actually made money in the process (sell high and buy low).

    There it is, a pretty unique situation where a 401(k) loan is the way to go. I don’t think that using a 401(k) loan is a good idea in general, for two reasons. First, you are taking money out of the market and missing out on compounding interest. Second, it is a risky long-term loan since the government will take a healthy bite if you lose your job and cannot repay the loan pronto. If you feel you must take a loan to pay off credit cards, then get a home equity loan (or just quit goofing around and pay the darn things off-putting credit cards on a 15-year amortization is a good way to stay poor forever).

    Also, I will add a note: The “non-deductability” of repayment is a non-factor. If I was taxed on the deduction, then it would be tax-disadvantaged. A 401(k) loan is tax neutral. I could take $10,000 out of my 401(k) as a loan today, pay it back tomorrow, and there is no additional tax bill. A bridge loan could be tax-advantaged, but I would have to pay interest/fees to a bank before I can get a portion of that back in taxes.

  21. Dennis says:

    Generally, I agree that borrowing money from your retirement fund is not a good thing. However, situations come up, and it happens…I did it once many years ago to make a down payment on a home. The main thing is that you’re losing out on the growth potential of the monies you took out. Yeah, well, consider this. What if you happened to time it just right and you took money out while the market was high, and suddenly during your payback period the market (and share values in your 401K) tanks (like now!)). This would be a good time to pour as much money as you can as fast as you can back into paying back that loan (when the share prices are lower then when you took the money out). I was contributing 12% (on top of my employer’s 5%) into my 401K before the loan. During the loan payback period, I adjusted my contribution to 5% (the max my employer matches), and then allocated the difference (7%) towards repayment of the loan. I have done similar things in the past with the cash value buildup on life insurance. That is, take out the cash value that has accumulated (and do whatever I want with it), then restructure my quarterly premiums such that $1 goes towards premium to keep the policy in force, and the remainder goes towards payback of the loan. Hoping and assuming the market will recover and the share prices in my 401K recover as well, by that time hopefully I will have paid off the loan and in so doing purchased A LOT of shares at a lot lower price. Just one other way to look at it.

  22. barba44057 says:

    Can your employer charge you a garnishment fee every pay period to process your 401K loan?

  23. Howard77 says:

    If you take money out of your 401K/403B to make a downpayment and purchase the house in the same year do you have to pay taxes on those funds at the end of the year? If not, how do you write that down on your taxes? Thanks!

  24. Marsi H. says:

    I am considering to take out a loan on my 401k of $30K to pay off debt at 10.24%. Previously my interest rate was 3.99, but I was late on a payment and the bank in anticipation of the new laws has increased my rate (per our agreement to a higher interest rate currently 10.24%). I called and asked them to lower the rate, yet they have declined my request. They said they only raised it partially and usually they raise it to 21% or higher for defaults.

    I recently purchased a home from my parents way below market value, but all the banks tell me I cannot refinance my home to get access to the ~$100K equity for 12 months because the lower of the purchase price and the appraised value is used to calculate the refinance amount. Therefore, I have to wait a year. I’d rather not pay 10.24% interest on $30K for a year. So what are my options since I don’t have those funds in a liquid account?

    Recently I’ve been thinking that I could either take out a 401k loan to pay off my debt or take out a lower interest rate personal loan to pay off my debt. With either option I would simply pay the loan monthly until I can refinance next year and pay off my debt completely. I have no belief that my job is in jeopardy. However, if I were to lose my job, I would just take out a personal loan to repay the debt to my 401k (another option). The reason I’m leaning to the 401k loan over the 401k is that either way I’m paying interest. Why not pay less interest and pay it to myself, especially since I’ve never attained the returns that everyone on this page seems to suggest that I’ll miss out on if I take my money out of the account for a year? Anyone have any answers/suggestions?

  25. Trixy says:

    Borrowing from your 401K isn’t the best option, and while most, if not all financial guru’s will tell you not to do it, there are some advantages. We looked at every option we have, like taking out a home equity loan, but as with most in today’s economy, we owe over $100k more than it is worth. No equity in our home.

    Long term borrowing (more than 1 year to pay back) is not advisable. However, if you can repay it in less than 12 months, it is something to consider. With the amount of interest we are paying on our credit cards, and over the long run, we actually can benefit by taking out a loan against our 401K. Yes, there are other con’s that we looked at very carefully, but we decided this was our best option in the long run.

    Unfortunately, on one of our CC’s, we are being charged 30% interest. I couldn’t figure out why that card was never going down when I was paying double the minimum amount if not more. Since I do everything electronically, I never looked at my statement so I started going through them and noticed the interest rate was 30%. I called last week to find out why it was so high and to try and get it reduced. Back in April I was 1 day late (they received my electronic payment the day after my due date). The CC company considers that dilenquent and up goes the interest rate for 6 months. Well, that wouldn’t be so bad, but I was 1 day late again in September so now I have another 6 months with 30% interest. I tried to get it reduced, but even tho I have been a card holder since 1992, credit in the 800′s, and was only 1 day late 2 times in the last 12 months, I am considered a “credit risk” and they will not reduce my interest rate. I was furious to say the least, but more pissed at myself for not getting my payment in one day earlier. And on top of that, I got hit with a late fee.

    I know borrowing isn’t the best option, but we have weighed all the pro’s and con’s and decided to go for it. Plus, if the economy was different and we were making a good return on our 401K’s, we probably would not be doing this. Since our 401K isn’t growing like it did in previous years, we aren’t losing that much in returns especially if we can repay within 12 months and put all that money back in there for when the economy turns back around. The loss right now is less than the interest we would be paying on our credit cards.


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