The pros and cons of a 401(k) loan
Borrowing from your 401(k) comes with risks and downsides that may cause more harm than good to your financial life. At the same time, there are some advantages for people in certain situations.
If you’re in need of money, it can be tempting to turn to your 401(k) for a loan. Is it worth it?
Why it matters: Borrowing from your 401(k) comes with risks and downsides that may cause more harm than good to your financial life. At the same time, there are some advantages for people in certain situations. Let’s dive in.
What is a 401(k) loan?
A 401(k) loan is a loan you take out from your own 401(k) retirement account. You borrow money from your 401(k) and pay it back over time, typically with interest.
Pros of a 401(k) loan
One of the biggest advantages of a 401(k) loan is that you don't have to go through a credit check or get approval from a lender. This can make it a tempting option if you have bad credit or are struggling to get approved for a loan from a traditional lender.
Another advantage is that the interest you pay on the loan goes back into your 401(k) account, so in a sense, you are paying yourself back. And because the interest rates on 401(k) loans are often lower than other types of loans, you may end up paying less interest over time.
Cons of a 401(k) loan
While there are some benefits to taking out a 401(k) loan, there are also some significant downsides to consider.
First, when you take out a 401(k) loan, you’re essentially taking money out of your retirement account. This means that the money you borrowed is no longer invested, and you may miss out on potential earnings over time. And if you leave your job before paying off the loan, you may have to repay the loan in full or face penalties and taxes.
Second, taking out a 401(k) loan can set a dangerous precedent. It may be tempting to dip into your retirement savings whenever you need money, but this can be a slippery slope that leads to long-term financial problems. The more time your money is out of your account, the less time it’s working for you. If that becomes your go-to when you’re in need of money, you may miss out on years of interest.
Third, if you are unable to repay the loan on time, you may face penalties and taxes. If you are under age 59 1/2, you may also have to pay an early withdrawal penalty on top of the taxes.
When is a 401(k) loan worth it?
In general, taking out a 401(k) loan should be a last resort. If you have no other options and need money for a pressing financial need, a 401(k) loan may be worth considering. However, it's important to understand the risks and downsides before making a decision.
If you do decide to take out a 401(k) loan, it's important to have a plan in place for repaying the loan on time. Make sure you understand the terms of the loan and the consequences if you are unable to repay it. And remember, the money you borrow will no longer be invested in your retirement account, so be sure to consider the long-term impact on your savings.