Is a 401(k) loan a good idea? When you should and shouldn’t borrow

Valuable Information on 401ks, Pensions, ESOPs, Form 5500 Preparation + More

loan, 401(k), employee benefit plansWhen employee benefit plan participants find themselves in tough financial positions, they often look for ways to relieve their financial burden. One of the options is taking out a loan from your 401(k) plan. However, is this a good idea? The answer – it depends on the situation.

For most people, the idea of taking out a 401(k) loan is like committing robbery on your retirement account and highly frowned upon. However, there have been studies that estimate nearly 20% of participants have loans outstanding on their retirement account. Clearly, this is a more common event than expected. For those in serious near-term liquidity situations who have very limited options, taking a loan from your retirement account might be one of the more cost-effective methods. This can be a participant who is not able to take out a personal loan from a bank and/or must rely on payday or pawn loans with extremely high interest rates.

Let’s look at a few situations where it may be cost advantageous to dip into your retirement account:

  • Getting these types of loans are quick and easy. There is no inquiry on your credit and usually can be taken from your 401(k) plan’s website.
  • Paying it back can be easy. For most plans, repayments are made through payroll deductions and are normally paid back in five years.
  • There are low upfront costs when compared to other loan types. Depending on the plan, there might be a small origination fee.
  • Interest rates are generally low and comparable to banks and significantly lower than payday and/or pawn loans.
  • You might lose less money during down markets. Interest rates paid on a loan might be less than the market value decrease during a recession.

In conclusion, don’t let the negative views on taking a loan on your retirement balance take that option away from you. When you are in a financial pinch, taking a loan from your retirement account might not be the worst option and could be your most cost-effective solution.

Patrick Herrera, CPA