Credello: The Pros and Cons of a 401(k) Loan

A 401(k) loan is when you borrow money that you have put into your 401(k) for retirement. More often than not, you can borrow up to $50,000 and up to 50% from your vested funds and repay it within five years. Interest rates are relatively low for this type of loan, so it is easy to get tempted to leverage that money when you are in a pinch. However, this can be much more damaging in the long run. 

Pros

If you are in a pinch, a 401(k) loan can provide an influx of cash at a low and stable interest rate. This money can be used for emergency situations, like holding you off while waiting for a job to start or unexpected medical bills. The interest rate itself is lower than most credit cards and some personal loans. 

Cons

The money you are borrowing from your 401(k) is pre-tax money, but the money you are repaying the loan is post-tax money. Say that your combined state and federal taxes are 20% - this means you are spending 20% more than the typical principal and interest payments. So even though the interest rate might be lower than other loans, you end up losing more money through this method. In real numbers, it looks like this:

You decide to take out a $15,000 loan from your 401(k) with an interest rate of 6% and you plan to pay it back in five years. Your monthly payment is $289.99, which totals to $17,399.52 over five years, or $2,399.52 in interest. If your tax bracket is 20%, it will cost $21,749.40 of earned income to pay that loan back. Of that, $4,349.88 is going directly to the government. In this scenario, the $15,000 is actually costing you $21,749.40. 

During the time that you are using your 401(k) loan, that money could be growing. Not only are you spending more to pay the loan back, but you are missing out on the opportunity for that money to be compounding. You are also losing out on years of contributions to your account, as many plans will not let you contribute until you completely pay back the loan. This adds thousands more dollars of money lost by taking out a 401(k) loan. 

The bottom line

If you are struggling to pay down debts, you can use a personal loan to pay off credit cards or consolidate your debts into one loan. Although 401(k) loans sound enticing, they can be much more damaging to future financial health than they are worth. 

Another option could be opening a home equity line of credit if you are a homeowner, as this can provide the money you need without being as damaging to your future. Especially considering the uncertainty of social security, you want to be able to rely on your 401(k) to get you through retirement.