This week’s blog in our Financial Planter series is written by Roger Wohlner, Guest Blogger, who is a Personal Finance Expert*
Many 401(k) plans offer the option of taking out a loan against the account. This provides participants with some flexibility should an unforeseen financial need arise. Advantages to borrowing from yourself include no credit checks and the interest amount you pay goes back into your account. However, there are some downsides.
Here are some things to consider before taking a loan from your 401(k) plan:
Taking a loan from your 401(k) reduces the amount of money available to grow and compound for retirement. While you do pay yourself interest, this is generally less than you could earn by having the money properly invested within your 401(k) account.
Will you reduce your contributions?
A study by Fidelity Investments® indicated that about 24% of 401(k) borrowers subsequently reduce the amount that they contribute to their plan.1 This is the ultimate “double whammy” for your retirement savings efforts. Many experts have pointed to the amount saved for retirement as the single biggest factor in achieving your retirement savings goals. Reducing the amount of your contributions, along with reducing your account balance by taking out a loan, can be a major step in the wrong direction for your retirement savings.
No flexibility in repayment terms
There is generally no flexibility in the repayment terms of the loan. If you run into financial difficulties you can reduce your 401(k) contributions, but the loan repayment schedule cannot be modified. Loans generally need to be repaid within five years, but the term may be longer if the loan is used for a down payment on a home.
Impact if you leave your job
In some cases your 401(k) loan becomes due and payable within 60-90 days from when you leave your job regardless of whether your departure is voluntary or due to a termination . This means that the loan will either need to be repaid right away or it could become a taxable distribution. If you are under 59 ½, a 10% penalty could also apply. Not all plans require immediate repayment and it’s best to understand how your plan treats these situations before taking a loan.
Top reasons for taking a 401(k) loan
According to a survey commissioned by TIAA-CREF2, the top reasons that people take a 401(k) loan are:
- Paying off debt
- Paying for an emergency expenditure
- Home purchase or renovation
- Covering expenses due to a job loss
- College costs
- An event like a wedding or vacation
While these are all valid reasons to take a loan, doing so will impact your retirement savings efforts.
A loan can make sense
Borrowing from your 401(k) to make the down payment on a home can make sense. There are no credit checks and the interest rate may be lower than borrowing money from a bank or other lender. This applies to other situations as well, not just borrowing for a home. The best strategy is to repay the loan over a shorter time frame than the ten or fifteen years that your plan may allow for a loan connected to a home purchase. While a home can be a great investment, getting the money back into your 401(k) plan so it can work for you will likely be a better long-term strategy.
The Fidelity study indicated that one of every two borrowers went on to take an additional loan from their 401(k) plan1. When does borrowing from your 401(k) cease to be the exception and become the rule?
Understand the implications
A 401(k) and similar employer-sponsored retirement plans are designed as retirement savings vehicles. Much has been written in the press about the retirement savings crisis in America. Borrowing from your 401(k) doesn't make your journey to retirement any easier. That said, be sure to understand the implications of taking a 401(k) loan. How will this impact your ability to save for retirement? Is your job secure and/or are you likely to leave this employer in the near-term in favor of another position elsewhere? Will you maintain at least your current level of contributions? Is this a one-time thing or the start or a series of loans? Most of all look at the implications, both good and bad, on your overall long-term financial plans. A 401(k) loan is an option to be used as tool if needed and not as a piggy bank.
*All content provided in this blog is supplied by Roger Wohlner and is for informational purposes only. Barclaycard makes no representations as to the accuracy or completeness of any information contained in the blog or found by following any link within this blog.
Roger Wohlner is an experienced financial writer and financial advisor based in Arlington Heights, Illinois. He uses his background and experience to explain complex financial topics in an engaging and informative fashion to a variety of audiences. Roger is the creator of the popular finance blog, The Chicago Financial Planner. You can follow him on Twitter and check him out on LinkedIn.