Should You Borrow From Your 401(K)?

July 03, 2014

Have you ever borrowed or thought about borrowing from your 401(k)? According to this recent study, almost half of those who took out a loan from their retirement plan later said they regretted the decision. So when does it make sense? Here are 3 situations:

1) A true emergency. No, we’re not talking about a new TV or even a much needed vacation. Some examples would be to prevent foreclosure or eviction from your home or repossession of your car. In this case, a retirement plan loan may be the least bad option. Just make sure it’s part of a long term plan to get back on your feet. The last thing you want is to eventually lose your home or car anyway AND have an outstanding retirement plan loan.

2) To pay off high interest debt. Not only are retirement plan interest rates relatively low, but the interest just goes back into your own account. That being said, there’s still a cost in the form of lost earnings on that money. As a rule of thumb, if the interest you’re paying on a loan is higher than what you can expect to earn from your investments (5-7% depending on how aggressive you are), it might make sense to use a retirement plan loan to pay off that debt. However, there are a couple of caveats. Once again, this needs to be part of a bigger plan. You don’t want to end up running the debt back up or filing for bankruptcy (retirement plan assets have special bankruptcy protection). Second, make sure you can afford the payments as the payment period is generally only over 5 years so the payments might be higher. They also tend to be deducted from your paycheck so there may not be an opportunity to prioritize other bills like mortgage and car payments.

3) To save money on a home purchase. To the degree that buying a home now can save you money in the long run (through lower home, mortgage, or PMI costs), this may be a good idea.  Just make sure that this makes financial sense and you’re not doing it for purely emotional reasons.

One last tip is that if you take a loan and are not allowed to take another one, you may want to borrow more than you need in case you later have an emergency and don’t have enough savings to cover it. Just be sure to keep that extra money in savings and not spend it frivolously. After all, this is retirement money and if you leave your job, any outstanding balance after about 60 days could be considered a withdrawal subject to taxes and a 10% penalty so you’ll want to have that money available to pay off the loan in that event.

What has been your experience with retirement plan loans? What did you use it for and do you regret it? Leave your thoughts in the comments section below.