3 things to ponder before taking a 401(k) loan
"Neither a borrower nor a lender be ..." With such a strong opinion about monetary transactions, Shakespeare would have hated 401(k) loans because you're both the borrower and the lender.
Is a 401(k) loan a useful financial tool or a trap for the unwary? It's potentially both, depending on your circumstances. Let's look at three things you should keep in mind before you proceed with taking a 401(k) loan.
Know the rules
About 90 percent of active 401(k) participants are allowed to borrow against their balance, according to the terms in their plan. Federal rules let you borrow up to half of your vested account balance, with the maximum loan capped at $50,000. In most cases, you need to repay the loan within five years, although a 15-year loan is allowed for the purchase of a home.
About 40 percent of 401(k) plans allow you to take out more than one loan at a time. Normally you repay the principal plus interest through a payroll deduction, with both the interest and principal payments added back into your account balance. In effect, you're paying interest to yourself. You can learn about your plan's loan terms, including interest rate, in the available descriptive material.
According to one recent study, about 20 percent of all active plan participants have at least one loan outstanding at any point in time, with an average outstanding balance of about $10,000. Over the five-year study period, about 40 percent of all active participants had a loan. About nine out of 10 401(k) loans are repaid in full.
While some financial commentators caution against taking a 401(k) loan, you won't be jeopardizing your retirement if you repay the loan back in full. Even if you default on the loan (generally a bad idea at any time), doing that on a loan balance of $10,000 won't make much difference to your retirement security because that amount won't last long with typical retirements of 20 years or more.
No matter the amount, however, you'll want to be thoughtful about taking out a 401(k) loan. Whether it's a good idea depends on a few considerations, which leads us to the second thing you need to keep in mind.
Consider your employment status
What are the chances you'll terminate your employment during the loan repayment period? This is the worst-case scenario for 401(k) borrowers, because most plans require you to repay the remaining loan balance in full within 60 to 90 days after you terminate employment.
In this case, about 86 percent of borrowers default, which results in counting the outstanding loan as a plan distribution. That means you'll incur income taxes and a 10 percent early-payment penalty if you're under age 59-1/2. And the amount defaulted won't be restored to your retirement savings.
Even if you don't plan to leave your job voluntarily, you'll want to consider the possibility that you could lose it during the repayment period. If your industry is under stress or your job is insecure, taking out a 401(k) loan may not be a good idea.
And if you do lose your job, you'll want to have a backup plan in place. Having available savings on hand to repay the loan is one idea, although many people won't have sufficient amounts (otherwise they might not be borrowing from their 401(k) in the first case). A more realistic option might be to pay off your credit card balances in full, so you can use them as a source of funds to repay the 401(k) loan in case you lose your job unexpectedly.
Be sure you've clearly determined the exact purpose of the loan
According to the study mentioned above, about 40 percent of all 401(k) loans are meant to consolidate debt and bills. Paying off credit card debt can indeed be a good use of a 401(k) loan because the average interest rate paid on 401(k) loans of just around 7 percent is far lower than the average rate paid on card debt, which is close to 16 percent.
The key to this strategy, however, is to have the discipline not to pile up more credit card debt after you take out the 401(k) loan. If you do, you'll have dug an even bigger hole for yourself by having two sources of debt -- the 401(k) loan and the new credit card debt. Heading down this bumpy path means you might not be able to use your credit card as a backup in case you lose your job and need to repay the loan in full.
About 30 percent of 401(k) loans are for home improvement and repair. In this case, if the repairs are absolutely necessary, or if there's a clear case that the improvement will enhance your home's resale value, the loan might make sense. On the other hand, taking out a loan for a hot tub or swimming pool might not be such a good idea.
The bottom line is that 401(k) plans are a great way to build long-term resources for retirement, but using a 401(k) loan for current consumption undermines this goal. On the other hand, using one to shore up your finances or build other assets might help bolster your long-term financial security.
And of course, if you're absolutely desperate and have no other sources, a 401(k) loan might take priority over building long-term savings. Turns out that advice about money isn't quite as simple as Shakespeare thought.