A 401(k) loan can cost you a lot of money if you don’t follow the right steps. We discuss the many 401(k) loan pros and cons to help you save more money and ultimately build more wealth.
401(K) Loan Pros and Cons: Is it Worth it or Not?
My next post is from Ashley Patrick, Ramsey Solutions Master Financial Coach and blogger at Budgets Made Easy. She helps families eliminate debt using simple strategies so they can stress less and live the life they want.
So, you are thinking about taking out a 401(k) loan.
Everyone says it’s a great option, has a low-interest rate and you are really “paying yourself back”.
You may be thinking, what’s the catch?
There are several reasons that a 401(k) loan is a bad idea, I know some of them from personal experience.
I personally would never do another one unless it was to avoid a foreclosure or bankruptcy and even then I probably wouldn’t do it.
When we took out a 401(k) loan it seemed like the best option. We found out the hard way why it is really a terrible idea.
Our 401(k) loan ended up costing us almost $1,000,000! There are many reasons that this type of loan is not a good idea and of course, they all happened to me! This can be damaging to your Personal Capital net worth calculation.
Before we get started on the cons of 401(k) loans, let’s talk about what they are and how they work.
What is a 401(k) loan?
A 401(k) loan is a loan that takes money from your 401(k) retirement account and then you pay it back in a time frame set by your employer.
How does a 401(k) loan work?
This type of loan works through your employer and the terms are set by them. You can borrow up to 50% of what you have contributed up to $50,000.
Generally speaking, you can only withdraw money that you have contributed and not what your employer has contributed.
However, the terms of the loan are all set by your employer. Some employers don’t even allow you to take out this type of loan.
The payments are taken out of your paycheck and applied to the loan. The loan is generally up to 5 years but the length of the loan is up to your employer.
Cons of a 401(k) loan
Here are a couple of reasons why it’s a bad idea in general but also why it was a terrible idea for us.
1. The loan has to be repaid quickly (30-90 days) if you leave your job, even if you are fired
If for some reason you are laid off, fired, or quit your job, the loan has to be repaid within a very short period of time. The time you have to pay it back is up to your employer.
This also means that you are stuck at your current job until it’s paid back. If you decide to change employers, the loan has to be paid back quickly and can’t be rolled over to the new job.
We took out a 401(k) loan to remodel our house after following the advice of “financially savvy” coworkers. Then my husband unexpectedly lost his job of 7 years shortly after completing the renovation.
We had 60 days to pay back the loan. Which we couldn’t do at that time. The money was already spent and my husband was unemployed.
If you are thinking “my job is secure, I’m not going to get fired”, my husband thought the same thing. He never expected to be laid off.
The amount of time for repayment is completely up to your employer. They get to decide how quickly you have to repay the loan.
For example, the majority of loans can be paid back within 5 years. Your employer could have it set to a max of 3 years instead.
They also decide how long you have to pay it back once you leave the company, no matter the reason for the separation. You could have to pay it back within 30, 60, or 90 days.
The loan can not be transferred to your new job even if you rollover the 401(k).
2. It is really a withdraw not a loan
When you take out a “loan” from your 401(k), you are really withdrawing money out of your retirement account.
When you do this, you are using your own money unlike when you take out a loan at a bank.
This is why when we couldn’t pay our loan back when my husband lost his job, we had a big tax hit the next year. The tax implications with it being a withdraw is a 10% penalty + your tax bracket.
I thought it was a loan using the money in our 401(k) as collateral. I was very upset when I checked the account and the money was gone.
We didn’t have any options to repay that amount in that short of time, so it counted as income come tax time.
We ended up owing around $6,600 in taxes the next year when we usually get back several thousand dollars. So in all, the $25,000 loan really cost us over $35,000 which doesn’t include losses in compound interest.
See Related: How I Save Thousands in My 401(k)
3. Losing compound interest
Since the loan is really a withdraw, you are losing stocks. This means that you are losing the wonderful magic of compound interest.
We were very young when we took out our 401(k) loan. Had we left the money alone, we would have an extra $1,000,000 at retirement age!
That’s a huge loss of compound interest.
Even if you repay the loan in full, you are losing out on years of building compound interest.
4. Changes in stock prices could cost you
Since you are withdrawing money out of your account, you are selling stocks and mutual funds in order to take the money out. As you pay the loan back, you are buying stocks and mutual funds back.
Considering the time it takes to pay the money back, the stock market will have changed since you sold the funds.
Generally speaking, the cost of those funds are going to be higher than when you bought them originally or when you sold them.
5. You’re paying taxes on your money twice
Since most people have a pre-tax 401(k), the money that you are borrowing was not taxed initially. When you make your payments though you are using money that you have already paid taxes on.
Whenever you withdraw the money come retirement age, you will pay taxes on the money again.
Depending on what your tax rate is when you withdraw the money, you could be paying an extra 25% or more in taxes.
6. High Fees
There can be high and hidden fees with these loans. Some as high as 7.5% just to have the loan. This is not including the interest rate!
There could also be annual maintenance fees on the loan. So, it will cost you more than just the interest rate and initial origination fees.
Pros of a 401(k) loan
Even with all the risks and downsides of a 401(k) loan, it may still seem like a good option.
In general, those arguments come from a couple of advantages of this type of loan.
1. It’s your money
This is one of the biggest reasons that this type of loan seems like a good option. You are borrowing from yourself. You are just taking money that you had saved and using it for today instead of in the future.
2. Don’t have to be approved
Since it’s not a traditional loan, your credit score doesn’t play a role in being approved. This type of loan is completely contingent on your employer and how they have it set up.
It’s a fairly easy process to get the loan and the money is typically distributed quickly. It also can go straight into your bank account.
It’s a quick and easy way to access money if it’s needed fast.
3. Payments are automatic
Since everything goes through your employer, the payments come out of your check automatically. You don’t have to worry about being late on a payment or not being able to pay it.
4. It’s a low-interest rate
The interest rate on these types of loans are generally lower than getting a personal or unsecured loan. If someone has bad credit, this type of loan can seem appealing compared to their other options.
See Related: 401(k) Alternatives You’ve Never Heard Of
FAQ of 401(k) Loans Pros and Cons
How much of a 401(k) loan can I take out?
You are only allowed to take out 50% of the amount that is in your 401(k) up to $50,000. You can not take out more than $50,000 no matter how much you have in your account.
Are 401(k) loans taxed?
The loan itself is not taxed, however, if you can’t repay it, it will be taxed. Even if you get laid off from work and can’t pay the money back in the short time frame, you will be taxed and have to pay a penalty.
Can I pay the loan off early?
Yes, you can but it’s a hassle to make the extra payment since the regular payments are automatic. I highly encourage you to pay it off as soon as possible though.
See Related: Best 401(k) Fee Calculators
Alternatives to 401(k) loans
There are better options out there especially if you have a good credit score.
A couple of things to consider when taking out any type of loan include:
- The reason for the loan
- Repayment terms
- Monthly payment amount
- Fees for the loan
Ideally, you should have emergency savings in case you need money quickly. Your 401(k) should not be considered your emergency fund.
Other options include:
- 0% credit cards
- Credit union loans
- Personal loans
Almost anything is better than borrowing from your 401(k). Personally, I put a 401(k) loan on the same level as owing the IRS.
It traps you into a job that you may not want or they may not want you anymore! Then you will owe a ton of money to the IRS if you leave your job.
The fees outweigh the low-interest rate. If you have other options, this type of loan should not even be on your radar.
The last option is to wait for whatever it is that you want the money for. This may not be an option depending on your circumstances but really think about it.
If you can delay whatever it is, then wait for it. Decide if it is really a need or a want and how quickly you could save up for it if you buckle down on your budget.
The rest of my story:
So after we owed a ton of money to the IRS for our 401(k) loan debacle, I put the money on a zero-percent interest credit card for 18 months.
To me, owing the IRS money is the last thing I wanted to do. After putting the money on a credit card, I started searching for debt payoff plans and came across Dave Ramsey and the debt snowball.
I got to work on my budget using a budgeting template and was able to pay off $45,000 in 17 months! So not only did I get that credit card paid off before the 18 months was up, but all my consumer debt!
Summary of 401(k) Loan Pros and Cons
Generally speaking, the withdraw is going to cost you way more than the original loan and is a huge risk. Any debt is a risk but the risks on this type of loan are higher in my opinion than a bank loan.
It is important to know all the risks associated with any type of loan. A 401(k) loan is very risky and costly even though it can look like an appealing option.
The risks far outweigh the benefits and other options should be considered before taking out these types of loans.
What do you think about these 401(k) loan pros and cons? Let me know in the comments below.
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Ashley Patrick is a Ramsey Solutions Master Financial Coach and owner of Budgets Made Easy. She has been featured on sites like Yahoo! Finance, CNBC, MSN, USA Today, and many others.