By Tracey March
If you need cash to finance the purchase of an investment property, you may be considering taking out a loan from your company 401k. About 75% of 401k plans have loan provisions, and 20-30% of people who have this option take advantage of it. However, while it’s great to have the option, taking a 401k loan can have serious and financially unfavorable consequences. In a nutshell: only consider a 401k loan if you have no other options, and if there’s no chance you’re going to go bankrupt or change jobs.
401k Loans: The Basics
Not all employers offer 401k loans, and some that do only allow them for specific reasons, such as to purchase a primary residence, prevent eviction from your home, pay for college, or cover medical expenses. The interest rates on 401k loans are typically quite good—often a percentage point or two above prime; however, your company has the discretion to set the rate. Federal law allows participants to borrow 50% of their vested balance, up to $50,000. Unless used to purchase a primary home, most loans must be paid back within five years; payments are made through payroll deductions. Some plans don’t let you make any contributions to your 401k until the loan is paid back, but most plans will allow you to accelerate your repayments.
401k Loans: The Downside
Generally, financial advisers say that taking out 401k loans is a bad idea for several reasons. Here’s why:
- You don’t earn returns on the loaned money during the loan period, effectively costing you money. Most experts believe that on average you double your invested funds every eight years; but you can’t double your money on the amount you withdraw for the loan. And consider this: you probably won’t double your money with a real estate investment in eight years.
- If your job ends (either you leave, or you are terminated), you have to repay the loan within a short period, typically 60 days. If you can’t, the unpaid balance will be considered an “early withdrawal” and you’ll have to pay a 10% penalty (if you are less than 59.5 and declare it as income).
- You have to repay the loan with after-tax dollars, which means you lose a tax benefit.
- Although some plans allow you to continue making contributions to your 401k during the loan period, you may need to make them smaller because of the loan payment.
- If you are in danger of bankruptcy, the money you have in a 401k is protected; however, any money you have borrowed on a 401k loan is not. If you are in danger of filing for bankruptcy, leave your money in the 401k.
- Former employers are unlikely to allow you to take a loan from a 401k that was funded while working for them.
401k Loans: The Upside
While there are plenty of drawbacks to 401k loans, there are some benefits:
- Any interest you do pay on a 401k loan goes back into your 401k account.
- 401k loans are convenient—no credit check is required, and often all you need to do to arrange for the loan is pick up the phone or complete a short application.
- Interest rates are typically low, and you pay the interest to yourself into the account, which means that it’s tax sheltered.
Be Informed and Realistic
While 401k loans may seem like a good idea, most experts say that if you are considering this type of loan, it’s a sign that you’re probably living beyond your means. Because you can expect to double your money invested in a 401k in about eight years, you?re probably better off leaving the money in your 401k and trying to borrow the money from another source. Also, don’t take out a 401k loan if you may change jobs or if there’s a chance you’re going to declare bankruptcy as the financial consequences could be very unfavorable.