The Pros and Cons of 401k Loans

If you need money and cannot get a loan, you may consider dipping into your 401k. Many companies allow their employees to borrow from their 401k plans. If you have this option, consider taking it. However, is it the best idea? Like most financial choices, 401k loans have their pros and cons. What are they?

The Pros of 401k Loans

No credit check is required. This is your money. Right now, your company is in control of it. Most employers are okay with dispensing loans since the money will eventually become yours. In fact, they do so without credit checks. Not paying back a 401k loan has many consequences. Due to that fact and the damaging financial impact, most employers know their employees will make good on repayment. That is why a loan is usually offered without a credit check. If you need money in a pinch and have poor credit, borrowing from your 401k may be your only option.

Low-interest rates, which you eventually recoup. As previously stated, the money in a 401k plan is yours. Your company is just in charge of managing the funds. For that reason, you are paying interest on your own loan. Not only are you charged low interest rates, unlike the inflated rates for payday loans, but you also get the money back!

You know what to expect. Your company has as much interest in your 401k as you do. They want to ensure you use the money adequately. Therefore, a company representative will do more than just hand you a check. They will work with you to ensure you understand the process. There should be no surprises. You know exactly how much money you borrowed, how much you need to repay, when, and the consequences of missing payments. With the recent concern about adjustable-rate mortgages, which surprised many mortgage borrowers in foreclosure, this should be welcome news.

The Cons of 401k Loans

Double taxation. 401k plans are tax-deferred. Any contributions to your account through payroll deductions reduce your taxable income. For example, if you earn $50,000 but contribute $2,000 to your 401k, your taxable income from the year is $48,000. Unfortunately, that money is taxed when withdrawn. Since you are required to pay that money back, you are taxed again. Why the tax? You are repaying a loan, not technically contributing to your retirement savings.

Many rules and restrictions. For starters, not all employers enable employees to take a 401k loan. If it is allowed, an application is required. This application is shorter than most bank-approved loans, but approval is not guaranteed. For the most part, businesses prefer to do short-term loans. These loans are typically repaid within 5 years. Car repairs or medical bills are considered short-term loans. Long-term loans, small to medium-sized companies stay away from. These expensive loans take much longer to pay off, like home loans.

You can lose money. When working to repay a 401k loan, most employees stop contributing to their funds. Remember, you are repaying the loan, not adding more to your account. Although the money is entering back into your retirement fund, it falls into a separate category. If you can, continue to make regular contributions. If you cannot, you miss out on free money from employer contributions.

Fees. You may be charged a fee for requesting a 401k loan. If this fee exists, your employer will determine its cost. On average, it is $50. This fee covers the cost of overseeing the loan.

As you can see, there are several pros and cons to borrowing against your 401k. So, what should you do? If in dire need of money, opt for a loan. Never borrow more than you need, use it as a last resort, try to continue with regular contributions, and repay promptly.