If you’re considering taking out a 401k loan and wondering whether or not it’s a good idea. Let’s weigh the pros and cons so you can have more insight into whether or not you decide to go forward and take out a 401k loan.
Taking out a 401k loan can seem like a good idea considering you’re paying yourself back in interest as opposed to a bank, if you need funds and have it available then it is definitely worth considering. Not that any of this is financial advice (and I’m not a financial advisor) but we can at least weigh the pros and cons of taking out a 401k loan. But first off, let’s start with the basics.
What is a 401k Loan?
A 401k loan is a loan you are taking out from retirement funds you have available in your 401k. So in essence, it isn’t technically a “loan” per say since you are the lender. It also doesn’t show up as debt on your credit profile because what you are essentially doing is withdrawing funds from what you have in your 401k and then being forced to put back in X amount each month until you get to the amount you withdrew. At that point, you are no longer forced to add funds back into your 401k.
In other words, if you have $50,000 in your 401k and you take out a $20,000 “loan”. Your balance would drop to $30,000 and you have $20,000 cash in hand. You don’t also owe an additional $20,000 of a loan. You just simply have to contribute whatever amount the monthly payment is until you add that $20,000 back (or more since you are paying yourself interest).
Pros
- You don’t need to get approved by a bank, so don’t need a credit profile
- You don’t pay interest to a bank, you pay yourself back in interest
- You can possibly get a lower interest rate than you would on a 3rd party loan as the rate is typically the prime rate plus 1 percentage point
- You can save money on loan fees as typically these will be much less than what a 3rd party may charge
- It’s not considered as “debt” when looking at your credit report or your overall net worth
- You won’t pay taxes as a penalty (unlike a 401k early withdrawal)
- It could be used to pay off collateral debt
Cons
- You lose out on gains from the money withdrawn, therefore it could end up costing you more
- You’re 401k has bankruptcy protections, therefore you lose that when pulling money out
- If you leave your job, you may have to pay it back quickly or face early withdrawal tax penalties
- You may not be able to take one out depending on your employer and their specific plan
- Due to the potential penalties of leaving your job, you may feel forced to stay longer than you want
- You are limited to how much of your 401k you can borrow
The Pros in Detail
Bad Credit Doesn’t Matter
The most enticing reason to take out a 401k loan is if you have bad credit. You don’t have to get approved by a bank, you simply qualify based on your employer’s plan which if allowed allots up to $50,000 or 50% of your 401k balance, whichever is less.
So someone with a 500 credit score, if they have money in their 401k can pull this money out and still get a low monthly payment as the interest rate is typically the prime rate plus 1 percentage point. So as of now this would give you a 4.25% interest rate, and looking back at the last 5 years could be as high as 6.25%. Your credit score has no bearing on the rate you pay. Either way, you’re paying yourself back this interest so even at the high-end this isn’t a bad deal. Especially if you’re someone with poor credit.
The other benefit is that usually the fee charged for taking out a 401k loan is $75 or even less depending on the plan. Paying any fee isn’t good, however, taking out a personal loan or car loan could cost you hundreds on the initial fee. I was even charged a $1,000 fee in my early twenties on a used car. Man to be able to go back now…
Another positive aspect of a 401k loan is that it doesn’t show up as debt while considering your overall net worth or your credit profile.
This could be good if you have a high debt to income ratio and don’t want to damage your credit score as that is one of the determining factors. You also don’t have to apply for a new loan which could be another item that could potentially hurt your credit score.
Avoid Tax Penalties of a Withdrawal
Moving on to the tax benefits. With a 401k loan, you don’t have to pay the taxes you would if you took out an early withdrawal from your 401k. If you take out a withdrawal there is a 10% withdrawal penalty and you’ll be paying up to an additional 20% in taxes. This means right off the top you’re only taking home 70% of whatever you actually took out, and the government keeps the other 30%. Not with a 401k loan. You don’t have to pay these taxes.
Pay Off Collateral Debt
Finally, one of the more underrated aspects of a 401k loan is that you can use it to pay off a collateral debt. For example, if you owe $15,000 on a car, then you could pay it off with a 401k loan so that you fully own the vehicle.
There could be a few reasons you would want to do this, but probably the main reason you would want to do this is if you wanted to sell your car (or other collateral). Most people would take it to a lot and trade it in for something more expensive. This is a good way to get double ripped off. A 401k could put you in a position where you could sell your vehicle without relying on a bank to approve your sale and potentially rob you of your hard-earned money.
The Cons in Detail
Plans Are Based on Employers
The first issue is that not all employer plans allow you to even take out a 401k loan, although it’s unlikely, you should make sure this is an option you have.
If it is an option, another downfall is that you can’t just take out the entire balance, you can only take out 50% or $50,000, whichever is the lesser amount. For most people considering taking out a 401k loan, the $50,000 maximum probably won’t be an issue considering the average amount for most people doesn’t hit six figures.
You Miss Out on Investment Returns
Assuming you’re able to take out a loan, the top concern is what you will be losing out on from your 401k market gains. This can fluctuate quite a bit from person to person depending on their asset allocation but the average tends to be between 5 and 8 percent. Although you’re paying the loan back (thus putting the funds back in) you will be losing out during the time frame it takes you to pay that back. So even though you’re getting a decent interest rate on the “loan”, it could still cost you more money considering what you may end up missing out on. We’ll get more into the math on this in a bit.
You Lose Bankruptcy Protections
Now we need to move on to the next major concern in taking out a 401k loan, which is the fact that you lose the bankruptcy protections that you have with your 401k account.
In other words, if you file bankruptcy you don’t lose what’s in your 401k. So if you have 50k in a 401k fund and take out 25k and end up having to file bankruptcy, you just lost that 25k whereas with a 3rd party loan it could possibly be discharged.
Filing bankruptcy should obviously be a last resort, but a job loss or unexpected life change is never planned on. In fact, I’m sure most people don’t plan on filing bankruptcy, but it’s something to consider when taking out a 401k loan.
Your Employer May Have Strict Payback Protocols
This brings up the next concern, which is if you leave your job. With a 3rd party loan you just have the same terms, but with a 401k loan, depending on your employer’s plan, you could be forced to pay it back quickly.
Some employers only give you 30-90 days to pay it back and if you’re unable to then you have to treat it as a distribution (distribute the amount outstanding on your loan from your 401k balance) and this has penalties attached with it. You may be able to get out of this by transferring it to an IRA, but not everyone will be able to do this.
Make sure to check your employers’ specific plan as some companies may allow you to pay it back as a loan with the same terms you are now, while others will force you to pay it in full in a month. Obviously, if you’re wanting to leave your job but have a loan that will immediately come due, this could force you to stay at your job longer than you want.
The Math
Nerd Alert** Let’s look at some math here to see how much you lose out on taking out a 401k loan, thus how much the loan actually costs you.
For this example, we’ll look at a $20,000 loan. We can use an ROI calculator to get results (it also considers taxes and inflation). Using an 8% rate of return means that $20,000 would have ended up being worth $27,790 in 5 years.
What we pay in interest on the loan doesn’t matter too much because we’re paying ourselves back, but we can use that to see what we would be putting back into our 401k each month as a “loan payment”.
Using a 4.25% 5-year loan makes our monthly payment $370.59, per Bankrate’s loan calculator.
So using the same ROI calculator and no initial investment, we can see where this would end up in 5 years by adding in the $370.59 per month. This leaves us with a total of $26,429 after the 5 years.
This means that the loan cost us $1,361 ($27,790-$26,429) plus any fees they charge. Not bad on a $20,000 loan. This would roughly be the equivalent of a 2.63% interest rate when considering the total amount of money it cost you for the loan.
Now, keep in mind this is with an 8% rate. If you’re ROI on your 401k is lower than that, then you would be “losing out” on even less! And since you’re paying interest to yourself you could actually come out ahead taking out a loan. However, if a good market is coming ahead and your rate of return would be higher, then you would be losing out on more. For example, a 15% ROI over 5 years using these same metrics would cost you $5,795 ($36,443-$30,648), which would roughly be the equivalent of a 10.5% interest rate. Yikes.
Either way, the monthly payment you are obligated to pay would be based on the prime rate so this could very well give you a lower monthly obligation that you have to pay.
That being said, we don’t know exactly how the market is going to play out the next 3-5 years. I gave 2 examples with an 8% ROI and a 15%. It’s up to you where you think the future market is going to be to determine what it will actually cost you.
Now you may be thinking, 8-15% are actually pretty good returns, what about someone that has a more conservative investment portfolio and is seeing returns of 3-5%?
Ok, let’s do some more math.
We’ll use 4% as the example here. So using the same ROI calculator on a $20,000 loan for 5 years, and assuming a 4.25% interest rate on your 401k loan, you would pay back a total of $24,262 into your 401k account after the 5 years is up.
$20,000 sitting in your account after 5 years of interest at a 4% rate without any additional investments would net you $3,639 leaving you with a total of $23,639. So $23,639-$24,262= -$623. That’s correct, negative $623, in other words, you actually ended up with more money from taking out a loan.
Say what!? How is this possible? It’s because you’re paying yourself back in interest and you’re putting in more than 20k in 5 years.
This means that the more you are paying in interest per month the less you are losing out on. So there actually is a benefit to having a higher interest rate on your 401k loan.
Granted, if you didn’t take out a loan at all you could use this “interest” you are paying to invest in something else, or pay down other debt, etc. However, we’re simply comparing the payback on the loan to not taking out a loan at all then this is where it would put you. If we didn’t include the interest paid towards your 401k then you wouldn’t be coming out ahead.
With that being said, you can see how taking out a 401k loan can be worth it, especially if you’re someone with bad credit.
Bottom Line-Should You Take Out a 401k Loan? (The break-even point)
Depending on what the future gains will be with your 401k and what you could potentially lose out on, what is the correct answer? Should you take out a 401k loan over a 3rd party loan?
What is the break-even point?
Well since we can’t actually know what the future holds with the market, we can’t get any definitive answer here. But, when we looked at what it’s going to cost you in terms of losing out on gains, it still seems to make pretty good sense unless you’re able to get a 3rd party loan with a low-interest rate and minimal fees.
It is also going to depend on your employer’s specific plan. You could have an employer that gives you the prime rate as your interest rate and if you quit your job you can still get on a monthly payment plan, while another employer may go with a higher rate and rather strict repayment options if you leave your job, like possibly making it all due in 30 days or face strict penalties. Obviously, these are going to make big differences in determining if it is worth it.
Again, losing out on your bankruptcy protections and considering your job security and ability to pay it back are going to be other determining factors in whether or not you should take out a 401k loan.
All of that being said. Here is my opinion on where you should take out a 401k loan compared to a 3rd party personal loan.
So, in other words, here is the rate you would want to get from a 3rd party lender for it to make sense to choose that over a 401k loan.
This is based on the current prime rate as I write this article being 3.25% and if you’re reading this at a later date and the prime rate is different than that then you’ll want to take that into consideration. However, as we just learned paying more interest on your loan means you’re putting more back into your account anyways.
BUT.
For Real Now-BOTTOM LINE
Best case: 2.5%, worst case 15%.
In other words, if you can get a 2.5% 3rd party loan with minimal fees then it’s pretty much always going to be worth it to take that option instead.
On the other end, in a worst-case scenario, it could actually make sense to take out a loan as high as 15% to avoid all of the negatives of a 401k loan.
If we condensed this down for the average person with the average 401k rules, then it wouldn’t be such a wide gap and really would be more like 4-7%.
But again, there are so many factors that go into play just realize that this is a generalization, and again, is my opinion on the matter. We can never have an absolute answer. Hopefully, this article gives you a better idea about where you think it’s worth it.
Conclusion
Taking out a 401k loan can be a great way to come up with funds during needed times as opposed to taking out a 3rd party loan.
It’s important to take into consideration all of the various factors mentioned in this article and determine if it is worth it for you or not.
What do you think about taking out a 401k loan? Do you think it’s worth it? Did this article help you at all in deciding whether or not to take that route? Let me know in the comments below!