401(k) Loan Overview
Statistics show that about one-half of the employer-sponsored 401(k) plans in the United States offer a loan provision for participating employees. Further, over 90% of the largest plans (plans with more than 10,000 participants) offer a loan provision. While some smaller plans do place restrictions on how the borrowed money can be used, most large plans do not. Surprisingly, relatively few plans allow the borrower to only take a loan for a large-ticket item such as the purchase of a home, tuition costs, and medical bills. This means that if anr employer allows you to take a loan against your 401(k) and does not place any restrictions on how the money is to be used, you are free to do with it what you like.
Restrictions on 401(k) Loans
Federal law limits loans against a 401(k) to 50% of the vested account balance, or $50,000, whichever is less. That means that you always have access to 50% of the money contributed through payroll deductions. But it is not always necessary to access the total amount of an employer's contributions. Since only 50% of the vested balance is accessible, this will be less than the total account value unless you are fully vested. Some plans, however, have much stricter limits, so it's always a good idea to confirm with your employer what, if any, qualifications must be met in order to receive the loan. Regardless of how the loan is used, the money borrowed must be paid back within five years. (The only exception to the five-year rule is with the purchase of a home.) Also by law, the plan must charge a fair and reasonable rate of interest. This is typically the prime rate plus 1%. Unlike the interest on a traditional loan that is paid to the bank or company that makes the loan, when borrowing from your 401(k) you pay the interest to yourself.
Some plans will also set the loan minimum at $1,000. Still others will impose administrative and service fees for processing the loan. And most require that the loan be paid back in equal amounts over the term. For example, excluding interest, a borrower who receives $25,000 may have a loan payback schedule of $416.67 each month ($25,000/60 months=$416.67 per month).
When to Consider a 401(k) Loan
How positive an effect a 401(k) loan has on your overall financial picture depends on the interest rate at which the loan is obtained, job security for the length of the term, and how the money is used. One other factor that is largely ignored is the state of financial markets at the time the loan is taken out. For example, if equity mutual funds comprise a large part of your 401(k), during a market downturn you could potentially lose money. If you've borrowed money from the account, the impact of negative returns will affect a smaller portion of your account. If the money is repaid before a market upswing, it's possible that returns will be greater than if the loan wasn't paid back at that time. This is by no means intended as advice to try to time the markets. However, it usually is not a good idea to take a loan against your 401(k) during a lengthy bull market.
The Benefits of 401(k) Loans
Loans taken from a 401(k) account are often much less expensive when compared to other, more traditional loan options. Banks and other companies that make loans, whether they are secured or unsecured, often charge double-digit rates of interest but pay a very small amount of interest on savings accounts. In other words, you could be paying 18%, 20% or more on a credit card, personal or business loan but only receiving 1% or 2% on the money in an interest-bearing account.
If your credit has been compromised due to the loss of a job or illness, a 401(k) loan may be your only option. A low credit score not only increases the amount of interest paid on a loan, it reduces the chances of qualifying for a loan in the first place. It's important to remember, however, that when borrowing the money due to financial hardship, it's critical to have a back-up plan in order to repay the loan.
Make Sure You Can Pay Back the Loan
While a 401(k) loan can be a solution in certain financial situations, it's not always the best way. Money that is borrowed from a 401(k) account won't earn interest until it's been repaid. While it may earn interest outside of the 401(k) account, it's never wise to assume a boost of overall return by investing a low-interest loan in a higher interest bearing account. In other words, don't borrow money from a 401(k) to speculate in stocks, options, or real estate. Remember too, that you'll owe taxes on the amount that is earned outside of a 401(k).
Finally, remember that 401(k) loans that aren't paid back on time will be subject early penalties if you are under age 59 ½. At present, the penalty is 10% of the total not repaid, along with having to claim that amount as ordinary income. If you leave or lose your job at the time of having an outstanding loan balance, you will have 60 days to repay the loan in full. If the plan allows for it, consider a repayment plan that automatically deducts the payments from your paycheck. That way, at least part of loan will have been paid back if you lose your job.
In the end, only you and your family can decide whether or not taking a 401(k) loan is right for your situation. Seeking the advice of a qualified financial planner may help you to review this and other available options. While it may not make sense to borrow against a 401(k) to pay off a low-interest car loan, it may make sense if you have high-interest credit card debt.
For those nearing retirement, bear in mind that the loan must be paid back in full before taking distributions.
Navigating the murky waters of finance can be tricky. There is far more information than we can cover here. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.
More 401k Guidance
- 401k Investment Guide — The complete guide to 401k investing.
- 401k Rollovers — How to roll over a 401k and avoid taxes.
- 401k Rules and Limits — 401k contribution limits explained.
- Solo 401ks — How to save money with a Solo 401k if you're self-employed.
- 401k FAQ — Over 30 in-depth 401k questions answered.