401(k) Loans: What are their pros and cons?

If you contribute to a 401(k) plan through your employer, it could be one of your most substantial assets besides your home.

And if money is tight and your savings account balance is running low, you might wonder how you can tap the funds in your 401(k) for a loan.

But you suspect there are both pros and cons of doing so.

Borrowing from your 401(k) is essentially borrowing money from yourself, but there’s much more to it than that.

So, before you decide to take out a 401(k) loan, weigh your options and determine if it’s really worth it.

What is a 401(k) Loan?*

A 401(k) loan is borrowing money directly from your 401(k) account balance. You then repay the loan, with interest, directly back to yourself, into your 401(k) account.

Your exact repayment plan is dependent on the amount you borrow and your 401(k) plan’s interest rate.

Note: A 401(k) loan is different from withdrawing money from your 401(k) account. When you withdraw money from your 401(k) account, it is subject to taxation. Also, if you are under the age of 59½, you will pay a 10% penalty for early withdrawal (there are a few exceptions related to hardship).

How Much Can You Borrow with a 401(k) Loan?

Though a 401(k) loan seems straightforward, when it comes to how much you can borrow, things get a little more complicated.

The allowable amount depends on whether or not you have had an outstanding 401(k) loan balance in the prior 12 months.

If you haven’t had a 401(k) loan balance for 12 months. In this case, the rules for borrowing from a 401(k) are pretty clear: You're allowed to borrow up to 50% of your vested 401(k) balance, or $50,000, whichever is less.

Examples:

• If you have $120,000 in your account; you can borrow up to $50,000.
• With $70,000 in your account; you can borrow up to $35,000.

If you’ve had an outstanding 401(k) loan balance in the last 12 months. In this situation, things get a little more tricky. You use the same 401(k) loan rules as above, but reduce the amount you're allowed to borrow by the largest 401(k) loan balance you’ve had over the last 12 months.

Examples:

• You have $120,000 vested in your 401(k) account and your largest 401(k) loan balance in the last 12 months was $10,000; then you can borrow up to $40,000 ($50,000-$10,000).
• You have $70,000 in your account and your largest 401(k) loan balance in the last 12 months was $5000; then you can borrow up to $30,000 ($35,000-$5000).

What's the Interest Rate on a 401(k) Loan?

The interest rate for a 401(k) loan is commonly 1-2% more than the prime rate. That being said, the actual loan interest rate you’re charged is dependent on your specific 401(k) plan.

What are the Terms for Repayment?

Most 401(k) loans are due within five years, but it depends on your specific plan. Some plans make exceptions and extend the terms to 10 or more years for home purchases.

Note: The term of the loan is only applicable if you stay with the employer that sponsors the 401(k) plan you borrowed against. Here’s one of the most significant risks associated with taking out a 401(k) loan: if your job is terminated (for whatever reason) with the employer who sponsors the 401(k) plan you borrowed against, the loan is due within 60 days. If you do not repay it within 60 days, the loan defaults.

How Can You Use the Funds?

Most plans do not place restrictions on what a 401(k) loan can be used for.

That being said, some plans only lend money if you use it for specific reasons, such as education, a first-time home purchase, or medical expenses.

What Happens if Your 401(k) Loan Defaults?

Your 401(k)loan will go into default if you fail to make payments, or otherwise, do not comply with the specific terms of your loan.

This also means that, if you lose or quit your job, and you do not repay the loan amount within 60 days, your loan will default.

When you default on a 401(k) loan, the money you borrowed is then considered a distribution from your 401(k) account. If it is counted as a distribution:

• you will pay taxes on it
• if you are younger than 59½, you will pay a 10% penalty
• you will not be able to use the borrowed funds to roll over into an IRA

If you default on a 401(k) loan, it is not reported to the credit bureaus and will not negatively affect your credit score. But that doesn’t mean it can’t have negative consequences.

Some lenders will ask specifically about 401(k) loan defaults, and this could still affect your ability to get a loan.

How Do You Get a 401(k) Loan?

Unlike most other loan applications, borrowing from your 401(k) is relatively simple and straightforward – and your credit score isn't a requirement for this type of loan.

Most Human Resources departments can provide the paperwork you need to apply for the loan.

Pros and Cons of Obtaining a 401(k) Loan

Pros of 401(k) Loans

• No credit check to qualify
• Easy loan application process with minimal paperwork
• Access the money quickly
• Not reported to credit bureaus (which means, it does not boost your credit score as you pay it off, but it also doesn’t affect your credit score if you default)
• Interest payments are made back to your account

Cons of 401(k) Loans

• The significant risk associated with a default (10% penalty & taxation)
• Loan due in full within 60 days of termination of employment
• Missed investment returns while money is not in the 401(k)
• Administration fees
• Loan payments are not considered 401(k) contributions
• Some employers will not allow you to make additional 401(k) contributions while you are repaying a loan
• Repaying a 401(k) loan does not increase your credit score
• The interest portion of the repayment is taxed
• Lost retirement savings

Still Considering a 401(k) Loan?

Keep in mind, while certain circumstances may make you consider it, you shouldn’t rely on your 401(k) for unexpected or unplanned expenses.

That’s what emergency funds are for.

Before you take the leap, remember your 401(k) may be your only retirement savings.

Most people don’t have pensions anymore, so many will rely on the money saved in their 401(k)to get them by in retirement.

*Not all 401(k)plans are created equal. Each plan has its own set of rules and terms for a 401(k) loan – and some don’t allow them at all. Contact your Human Resources department and consult your plan description to see your specific options.