December 8th, 2011
The Pros and Cons of Borrowing from Your 401(k)
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**Today’s guest post is contributed by Sandra Parker of PT Money: Personal Finance.**
When it comes to finding money to take care of financial obligations these days, your options are even more limited than ever before. Thanks to the credit crunch, banks and other financial institutions have made it more difficult than ever to borrow money. Those that will lend will only do so to individuals with an excellent credit score and charge a premium for the privilege. Many people are caught in the crosshairs and simply don’t qualify for a loan.
So, what are your options if you are having trouble finding financing and need a few extra dollars for an unexpected expense?
This is my story.
Earlier this year, my brother-in-law passed away unexpectedly. While both my husband and I have good jobs, we didn’t have the nearly $14,000 it took to bury him and we had no idea whether or not he had life insurance. My husband had been saving for the past three years to purchase a Harley Davidson touring motorcycle, so thankfully we had some money stashed away, but we were still short. We didn’t have the time to apply for a traditional loan and my credit cards were still maxed out thanks to some hefty Christmas shopping, so I turned to my 401(k) for the extra cash.
I didn’t withdraw the money outright, though I could have under the hardship withdrawal terms. I chose instead to take out a loan against my balance to cover the shortfall. I knew that this move would impact the money I would have at retirement, but at 37, I figured I would have plenty of time to make additional contributions. Plus, I didn’t have to worry about qualifying for the loan or taking a hit on my credit and I could access the money within 24 hours, which relieved a lot of stress.
Here’s how it works:
Contact your 401(k) administrator and complete the necessary paperwork. Designate the amount of money you wish to borrow and then set the loan terms. In most cases, you can borrow up to 50 percent of your 401(k) balance and take up to five years to pay it back. Then, sit back and wait for the check or money to be directly deposited into your checking account.
Sound too good to be true? It can be. While the loan process is extremely simple and you will qualify regardless of your credit history, there are some drawbacks to taking money out of your retirement, even in the form of a loan.
- The money you take out will no longer be able to earn compounded interest, meaning that you can put a serious dent into your post-retirement funds by taking out a loan. And, the longer the term for repayment, the more devastating the impact this particular downside will have.
- The payment may hamper your ability to continue making future contributions to your account. This will also reduce the amount of money you will have in your account for your retirement.
- If you lose your job, the remaining balance on your loan will be due within 60 days of termination. Failing to pay it back within the timeframe will result in a default on your loan, which is extremely expensive. Not only will you have to pay regular income tax on the money, but you will have to pay a 10 percent penalty fee for early withdrawal.
- You will have an additional tax liability. Payments on your 401(k) loan are withdrawn from your paycheck on an after-tax basis, not like your pre-tax contributions. So, your paycheck will not only reflect a lower amount due to your payment, but will have additional taxes withheld.
Now, with all of that being said, using the loan feature on my 401(k) plan was a lifesaver for me this year. I have since repaid this loan and taken out a second loan to pay off my high interest rate credit card debt. For my situation, paying off my high interest debts with a low interest loan from my 401(k) made sense since I could use the extra money I no longer had to send to my credit card companies to make catch-up contributions to my 401(k) and offset some of the loss I would experience from taking out the loans. Plus, because the interest rate is so low on my 401(k) loan, my debt was paid in half the time it would have taken me had I left my balances on my cards.
Before jumping into a 401(k) loan to finance a vacation or home improvement project, make sure you take into consideration all of the impacts this move can have on your future.