Should I Borrow From My 401K?

Posted: September 17th, 2010 | Author: | Filed under: Debt, Retirement | Tags: , , , | 2 Comments »

Many Americans may find themselves asking this question in today’s economy. The Great Recession and its historically high level of unemployment have left many with few other options. In the past, people could refinance their mortgage or take out a home equity loan but the collapse of the housing market has left many underwater. So it may seem like a last resort, but is a 401k loan a good idea?

401k 300x225 Should I Borrow From My 401K?

Photo by {Guerrilla Futures | Jason Tester}

 

A BankRate reader recently asked Don Taylor just this question. Here’s the gist of don’s reply.

Don points out that it’s notoriously difficult to “run the numbers” to compare the cost of a 401k loan vs. other debt (ex: will you save money borrowing from your 401k to pay down your car loan) because it’s impossible to know for sure what the 401k loan will really cost you in the end. It’s easy to compare interest rates, and the financing cost of the loan, but you can never truly account for the lost compounding effect from having that money continuously invested (and any dividends re-invested). In short, you can’t know for sure what the cost of having that money side on the sidelines is going to be.

Still, there are some situations where it can be less of an impact, if not an actual benefit to borrow from your 401k.

Here’s a list of when it might be beneficial to borrow from your 401k:

  1. If you would need to borrow the money anyway from another source, if not your 401k.
  2. If the after-tax interest rate on that other loan would exceed the “reasonable return” you can expect from your 401k over the term of the loan.
  3. If you can make your 401k loan payment without reducing current 401k contributions.
  4. If you accept the terms that you will need to repay any outstanding portion of the loan within 90 days of leaving your job or pay income tax on that balance along with a 10% penalty.
  5. If the borrowed money is going toward repayment of a loan with no tax deduction (i.e. credit card debt).
  6. If you get your financial ship in order to avoid the need to borrow so much in the future.

I added those last two points because I feel they’re important. I also don’t think it’s ever really a good idea to borrow from your future like this unless your present way of life is really in danger of ending. In other words, you have exhausted all other avenues and bankruptcy is not a way out.

I’ve had friends who have borrowed from their 401ks and never been able to pay them back because they never got their spending habits under control. This only serves to set them back financially in a big way.

In my own experience, when I’ve had to come up with some extra money to pay off debts, I’ve stopped contributing to my 401k and diverted that money toward the debt as extra payments. It’s painful at the time, but less painful than borrowing from my 401k, which only shifts the debt around and ends up costing much more in the long run.

It’s important to note that Don bases these points off of a paper by members of the Federal Reserve Board titled “New Evidence on 401(k) Borrowing and Household Balance Sheets.” This paper is also referenced by the Wall Street Journal article, “Rethinking Conventional Wisdom About 401(k) Loans.”

UPDATE: Thanks to NerdWallet for featuring this post it its Carnival of Money Stories – Oktoberfest Edition, and Personal Dividends for featuring this post in their Carnival of Wealth #4 – The Family Finances Edition.

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