401(K) Loans: The Dangers of borrowing from yourself

Loaning money to yourself from a 401(k) may seem like a great idea.  After all, these loans result in paying interest to yourself rather than to a lender which may lower overall interest costs.  Additionally, 401(k) loans do not require credit checks or a lengthy application.  Instead, the process of taking out a loan is fairly simple.  The benefits of 401(k) loans has led many savers to use it as a go-to tool for addressing financial shortfalls.  In fact, according the Employee Benefits Research Institute, nearly 20 percent of all 401(k) participants had a current loan outstanding. While a 401(k) loan can be significantly more attractive than other financing alternatives, participants need to understand all of the implications before getting started.

The terms

401(k) loans allow participants to borrow the lesser of 50 percent of the account balance or $50,000.  For example, a participant with a 401(k) balance of $200,000 could only borrow $50,000. While the interest rate charged on the loan is generally 1 to 2 percent higher than the prime lending rate, you are paying yourself back with interest. The payments are made through payroll deductions on an after-tax basis and loan terms generally have a payback period of five years with no pre-payment penalty.  If all that sounds good so far, why might a 401(k) loan be a bad idea?

First, the obvious – you are tapping funds earmarked for tomorrow (retirement) to cover financial needs for today.  Remember, any funds that you have removed from your retirement account to lend yourself are no longer invested and working for you. Lower balances may result in less tax-deferred growth of your plan.  Additionally, some participants may no longer be able to afford to make their regular 401(k) contributions while also paying back their 401(k) loan.  In fact, according to the human resources firm Aon Hewitt, participants with an outstanding loan are contributing on average 2 percent less of their salary to their 401(k) than those without a loan.  So not only is less money working for you, but those with a loan usually have to reduce their contributions to repay the loan which can result in significantly less money saved for the future.

Don’t let your 401(k) get repossessed

There’s also the repercussions of changing jobs to consider — one of the biggest risks of a 401(k) loan. Should you leave your employer for any reason before your loan is paid, you generally have 60 days to pay back the loan in full. That’s right — only 60 days. In the event that you are unable to pay back the loan, the loan is fully taxable and could be subject to a 10 percent early withdrawal penalty if you are younger than age 59½.

With the average worker changing jobs every 4 years or so, many participants are faced with this harsh reality. According to the National Bureau of Economic Research, a whopping 86 percent of borrowers that leave their employer end up defaulting on their loan.  Additionally, some workers end up staying at employers they might otherwise leave due to the fear associated with defaulting on an existing 401(k) loan.  Bottom line – you never want to be in the position where you stick around at job that is not congruent with your long-term career goals simply because of a 401(k) loan.

Prior to borrowing against your 401(k) plan, be sure to familiarize yourself with the rules of your specific plan by speaking to your plan’s administrator and human resources department.  Also, be sure to exhaust other funding options such as a home equity loan or line of credit before tapping your retirement plan.   The potential tax deductibility of home equity loans may make them an important option worth reviewing.  While 401(k) loans can be costlier than you think, they are certainly a better alternative than cashing out your plan completely or paying ultra-high interest rates on other debt.

Financial emergencies do happen and a 401(k) loan may be your only choice.  However, be sure to proceed with caution.  Since everyone’s situation is unique, consider speaking to your tax, legal and financial advisers to determine the most appropriate approach for you.