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Should You Take Out a 401(k) Loan?

When you’re strapped for cash and trying to find a way to make the bills balance, borrowing may be your only solution, and it’s certainly tempting to choose a lender who doesn’t factor in your credit score or your past history before making this decision: yourself. Yet, while it’s true that taking out a 401(k) loan amounts to borrowing from yourself, the consequences you may face from using retirement funds now — even if you pay them back — are far costlier than a side-by-side loan comparison makes them seem. In fact, except in very rare circumstances, borrowing from your 401(k) is an incredibly risky move that doesn’t make sense for most people.

401(k) Loan Rules

Like any sort of financial product, borrowing from your 401(k) means you need to follow a specific set of rules that govern the alternative utilization of this account. Make sure you understand each of the following provisions before making any moves to borrow from your 401(k):

>You may take a maximum of half the value of your account or $50,000, whichever is lower.
>The loan must be paid back within 5 years of disbursement, though extensions can be made for loans used as a down payment on a home.
>401(k) loan interest payments are made to yourself and the account, but are not tax deductible.
>All loan payments, plus interest, are made with after-tax dollars, unlike 401(k) savings, which are made pre-tax.
>If you leave or lose your job, the balance of the loan is due within 60 days.
>Each plan is different, but there may be additional fees, such as a loan initiation fee or annual fee, that you pay directly to the provider (for example, a retirement savings company such as Fidelity.)

Failure to follow these rules can have massive consequences that can leave you hanging out to dry once retirement finally rolls around. In fact, failure to properly pay back a 401(k) loan subjects borrowers under the age of 59 1/2 to the standard pre-payment penalty of 10% plus the cost of taxes on what is now income.

Other Types of Loan Alternatives

As the country’s number one provider of 401(k) retirement plans as of August 2016, getting a Fidelity 401(k) loan is actually a pretty easy process. Almost all —about 94% — of large- and medium-sized business plans, regardless of their issuer, offer the option to borrow from employee 401(k) contributions, and nearly three quarters allow you to borrow from employer contributions. But the cost of doing so is more than you may realize. Check out this

While the right route for avoiding the need for a 401(k) loan is to have an adequate savings and emergency fund, if this is simply not your case, there are equally simple and often better alternatives out there if you need cash, especially for debt consolidation.

Personal Loans

Personal loans make up a broad category of official and unofficial financial products that offer you fast access to cash. Personal loans can include everything from credit card advances and payday loans, along with their very high interest rates, to 0% interest credit cards and loans from family and friends.

Especially when you only need the money for a short time (for example, until your year-end bonus) these other fast options and quick payback periods are far less risky and are cheaper than a long-term 401(k) loan and the lost opportunity for retirement growth that comes with it.

Secured Loans

Secured loans, particularly home equity loans and home equity lines of credit, are often a better option for homeowners looking for cash. Not only do secured loans often come with lower interest rates because they’re secured by real property as collateral, but they also offer tax breaks in the form of interest payment deductions at the year’s end. Especially when using the cash from your loan to take care of emergency situations such as home repairs, home equity loans are a safer, lower-cost option for long-term debt.

Unsecured Loans

Unsecured loans are institutional financial products offered to borrowers based on factors such as their credit score, employment history and debt-to-credit ratio. This is a good option for non-homeowners with good credit scores and steady employment. In fact, many online personal loans are offered with low interest rates that are as much as half that of high-interest credit cards, making them an excellent solution for debt consolidation and interest rate savings on long-term debt.

Summary

Taking a 401(k) loan may seem like a simple solution to a cash flow problem, particularly in an emergency. After all, the money you’re “borrowing” is yours to begin with. Studies have found, over and over again, that taking that first 401(k) loan can be a gateway decision that leads to more borrowing from your 401(k). When you couple this with the fact that most Americans are vastly underfunded for retirement to begin with, it’s easy to see how the real opportunity costs of this loan, which reduce the amount of money you invest and compound over time, can lead to a lot less money for retirement and more financial problems down the line.

When used as a last resort or financial Hail Mary, a 401(k) loan can be a lifesaver but, like any easy fix, this one can be easy to abuse and may make you poorer in the end.

NOTE: Here is the section with the odd KW “401(k) loan calculator” — let the client review this to see if they want to keep it in with the link. If not, these sentences can be deleted and the article will still read fine.

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Published August 11, 2016
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