## Should I take a 401(k) Loan?

Are you considering taking out a 401(k) loan? If so, you are not alone.

I wanted to know what people were saying about the appropriate reasons to take out a 401(k) loan, so I went to Google and typed “Should I take a…” and Google filled in the remainder “401(k) loan”. Apparently I’m not the only curious one out there. After reading half a dozen articles that were obviously plagiarized, it was clear to me that a flat screen television is NOT an appropriate reason to take out a 401(k) loan. All six articles told me so. But is that really the case?

First, let’s be straight with each other. You are an adult and, by the simple fact that you HAVE a 401(k) balance, I can assume that you are at least mildly responsible with your money. I doubt you are looking for advice not to use your retirement savings to buy a television. But let’s examine the 401(k) flat-screen purchase as a case study.

A reasonable person might say that taking a 401(k) loan to buy a television is crazy. That same, reasonable person might go down to Best Buy and purchase a television on his or her credit card, paying it off over six months at an 18 percent interest rate. Who is crazy now?

The real question is not what you are using the loan for, but are you going to get a loan? If your answer is yes, it doesn’t matter what it is for. It is simply what you are going to do. You are now ready to evaluate whether you should get a loan from a bank or from your own 401(k) account.

So let’s crunch some numbers.

A 401(k) loan is typically painted as a bad idea; like stealing from your savings. When making a decision about money you should evaluate it as rationally as possible. The merit of this financial transaction will be measured in its monetary value to the owner of the 401(k) account, not by public opinion.

The monetary value to the borrower is called cost advantage (or for you Econ 101 students, you could call it opportunity cost). The cost advantage of a 401(k) loan is the difference between the interest rate on a loan from a bank, and the rate of return on your investments if you were to leave them in your 401(k). To figure out you cost advantage, follow this simple formula.

Cost Advantage = Interest Rate of Bank Loan minus Investment Return on 401(k) Funds

Example: You can obtain a car loan at 6% APR from your bank. Your 401(k) had a 4% return last year and you don’t expect a dramatic change in the near future. Your cost advantage is 2% (6% bank loan interest rate minus 4% predicted return on 401(k) funds). In other words, if you took the loan from the credit union you would pay 2% more in interest than you would make in investment returns if you left the money in your 401(k). You should consider taking the loan from your 401(k).

Another example: You are considering the same car loan but the market is doing well and you are seeing a 10% return on your 401(k) each year. Your cost advantage is now negative 4% (6% interest rate minus 10% return) or, in other words, you will lose out on 4% of investment returns from your 401(k) if you withdraw the loan for the car. In this case it makes more sense to take a loan from the credit union.

Since the interest rate charged on your 401(k) is paid back to your own account, you need not factor it in to the decision making process, except for cash flow reasons while paying back the loan. Consider interest paid on your 401(k) loan as an additional investment into your own retirement account.

Hopefully this has given an additional insight on the way you can evaluate a 401(k) loan. Obviously, every financial situation is different and this is by no means an exhaustive approach to such a complex financial decision. As with all financial decisions, it never hurts to ask for advice from a trusted professional.

Rex Platt

[…] August 2011, Rex talked about reasons to take a loan from your 401(k) plan. Hopefully you also noticed the caveat at the bottom that all financial situations are different, […]