Borrowing against your 401K is rarely a good idea. But of course there are some cases where it may make sense. Let’s take a look at the good, the bad, and the ugly.
But first let’s talk about some reasons that you may want to borrow. Let’s say you want a new boat, or maybe a plasma TV. Don’t even think about it. Your future is much more important than the pleasure that you may get from those items. But let’s say you are renting a house and a great buy on a dream house comes on the market. You know that you will be walking away from the table with equity. You and your spouse have secure jobs and plenty of savings, and you are on a solid financial plan. But you don’t have the down payment required to get the house. In this case I would say that it is a no brainer. Jump on it. Buying a house is normally a great investment. You will be buying a future for yourself instead of someone else. When you rent, you are actually paying for someone else’s house and you leave with nothing.
Let’s think about what is actually happening here. You are borrowing money from yourself and paying yourself interest. Better than paying a bank, if you were going to do it anyway. Let’s say that you were earning 11% and your rate was 9%. You would be earning 2% less, plus you would be losing the tax advantage. Doesn’t seem like much now, but it could be a huge amount at the end when you retire. Of course if you end up with a free and clear, mortgage free home because of it, than I would say that you made a very wise decision.
Plans vary some so check with your employer before you make any serious commitments. Normally you have 5 years to pay back the loan. If you used it for a new home purchase you may have up to 30 years to pay it back, but some plans limit it to 10 years. Rates are competitive and could be around the prime plus 1%. Normally you can borrow up to $50,000 or half of what you have in the plan, which ever is smaller.
Let’s look at the good. The loans are normally quick. You don’t have to qualify (except to yourself!). The interest rate is usually quite competitive, plus you are paying it to yourself. If you took the money out instead of borrowing, you would have paid a 10% penalty for early withdrawal.
And the bad. You are slowing down the growth of your retirement fund. Some plans do not let you make contributions while you are paying it back. Ouch.
And the ugly. If you leave your job, you will have 60 days to pay the loan back. If you couldn’t you would have to pay the 10% early withdrawal penalty plus taxes on the whole amount. Double ouch!
So what is the answer? I would say that it is rarely a good idea. I have shown a scenario where it would be a good idea, but all situations are different. Only you can decide if it is a good plan for you. So if borrowing against your 401K can make you a nice investment for your future, or get you through an emergency, it may be an alternative to consider. Do your research and ask a lot of questions before making the decision. It will have an affect on your future!