Have you refinanced your home into oblivion? Tapped out every available money resource with a myriad of loans and credit cards? There is one last option: borrowing from your 401(k). If you’ve never heard of this option, it’s because until recently, it just wasn’t done that frequently. But with the market still not fully recovered, and people desiring to cut their high-interest debt, more folks are discovering this alternative lending source.
Before you go off half-cocked, it is crucial that you understand the pros and cons. Don’t forget that your 401(k) is your retirement nest egg, and you are putting that nest egg into possible jeopardy. If you’re thinking of borrowing from your 401(k) to buy a luxury automobile or a larger home, stop. Mortgaging your future to live a lifestyle that’s beyond your income, while it’s become the American Way, is a mistake. But if you’re trying to get out from under high-interest debt and plan to use this opportunity to live within your income, it could be your ticket to becoming debt-free.
Here’s how they work: most plans allow you to borrow up to half of your vested balance, but not more than $50,000. You apply to the company that manages your 401(k) plan, but you don’t have to “qualify”—after all, you’re borrowing money from yourself. You sign a promissory note and receive the money within a couple of weeks. The interest rate is usually equal to the prime rate or slightly over, so currently you’d pay 3-4 percent interest. You then have five years to repay the loan, and most of the time, you make payments through payroll deductions.
Now let’s look at the pros and cons of borrowing from your 401(k):
• A 401(k) loan does not appear on your credit report. They are not reported to Experian and do not become a part of your credit history.
• The interest on these loans is some of the lowest out there—right now, 3-4 percent.
• You’re paying yourself the interest, not some bank.
• You’ll get your money more quickly than if you were using another means of borrowing.
• Since it’s a loan, you will not be charged the 10 percent early withdrawal penalties plus income taxes you would have to pay if you withdrew the money.
• You don’t have to qualify for the loan through the usual long, painful credit approval process, because in effect, you are the lender.
• No assets or collateral are needed to secure the loan.
• The biggest con is that you are forfeiting the accrued interest you would earn if your money stayed in the 401(k). Calculated over the long term, it can cost tens (even hundreds) of thousands of dollars in potential gain.
• Unlike a home equity loan, the interest is not tax deductible.
• Some plans do not allow contributions to the 401(k) for the period of the loan.
• If you lose or quit your job, the loan is often due in full in 30-60 days (although some plans are open to renegotiating the terms of the loan. Find out before you sign the papers.)
• If you default on the loan, it is considered a withdrawal and you will owe a 10 percent penalty plus a hefty tax payment. So if you had borrowed $50,000 and couldn't pay it back, you would have to pay a $5,000 penalty and federal and state taxes that could take another $20,000 of the amount.
To calculate the actual cost of borrowing from either source: for a home equity loan, ignoring upfront costs, the after-tax cost is the interest rate minus your tax savings (interest rate times 1 minus your tax rate).
The cost of borrowing from your 401(k) is what your loan would have earned had you kept the money in the 401(k). Since your 401(k) accumulates tax-free, the total return on the fund is a close approximation of the after-tax cost.
Let’s say you need to borrow $10,000 and you have $100,000 in your 401(k) earning an average of 10 percent a year. Interest on a home equity loan is 8.5 percent and you are in the 28 percent tax bracket. The after-tax cost of the home equity loan is 8.5x(1 - .28) or 6.12 percent. The 10 percent cost of borrowing from the 401(k) is higher than the 6.12 percent cost of the home equity loan.
If both loans are repaid in full after one year: if you use a home equity loan, you will have $110,000 in your 401(k), you’ve paid the lender $10,850 in interest and you have a tax savings of $238. Your financial wealth will therefore be $110,000 - $10,850 +$238 = $99,388.
If you borrow from the 401(k), you will have only $99,000 in your 401(k) at the end of the year because you haven’t earned the 10 percent on the $10,000 you borrowed. Whatever you pay back to the fund does not affect your wealth. You are thus $388 poorer if you borrow from your 401(k).