6 MIN READ
This is What Happens When You Borrow Money From Your 401(k)
Christine Cummings and her fiancé recently found their dream home. However, neither of them had been in the home-buying market for quite some time, and they thought they wouldn’t need their down payment until the closing date. But when they went to sign their mortgage papers, the bank asked for the lump sum — that they didn’t have — in less than a week.
The hurdle? Cummings, the vice president of marketing for All Set, is an immigrant from Germany who’s here on a working visa. She worked in Europe for more than 30 years, and the majority of her savings was sitting in a European bank. Because international money transfers involve a lengthy process, she wasn’t sure she would get her portion of the down payment in time.
An idea popped into her fiancé’s head: After hearing his friends talk about taking short-term loans from their 401(k)s, he decided to explore the option. He realized getting the loan would be as easy as logging into his account and paying a fee of less than $20.
So, they did it. They took the 401(k) loan, made the down payment on the house and reimbursed the account as soon as Cummings’ funds from Germany arrived.
“There was a little bit of a thought process because we’re both under the understanding that you don’t want to touch your 401(k), you know, until you retire,” said Cummings. “But since we knew we had the money and that we had to do it to beat the processing time for the money from Germany, we just decided to go for it.”
401(k) Loans: Part of a Bigger Problem
While Cummings had enough money to cover her down payment, not everyone else is in a similar situation.
In general, Americans are lacking when it comes to having cash on hand.
According to a recent GoBankingRates study, 69% of Americans have less than $1,000 in their savings accounts.
This means they often don’t have the means to cover emergencies, let alone make major purchases, such as a home.
So, some folks are tempted to take a loan from their 401(k)s.
There are rules associated with doing this, though.
Forbes reports that most 401(k) plans allow you to take out loans, although specifics vary by plan. Typically, you’re allowed to borrow up to 50% of your entire account balance up to $50,000 You must repay the loan within five years, although the repayment schedule can usually be extended to 10 years if you use the loan to pay for a down payment on a home.
But is it really a good idea?
We spoke to some experts to find out.
When is it OK to Take a 401(k) Loan?
Some financial planners say taking money out of a 401(k) strategically can work to your benefit.
Pedro Silva from Provo Financial Services says taking money out of a retirement fund can be appropriate if the money is put toward a long-term goal that helps you build a better future.
Silva says it may be appropriate to use a 401(k) loan to eliminate consumer debt, buy a home or start a business, but he also warns of situations when you should never take out a 401(k) loan.
“401(k) loans should typically not be used for treating ourselves as in vacations or for depreciating assets, such as a car or a boat,” he said.
But Travis Sickle of Sickle Hunter Financial Advisors in Tampa, Florida, says he finds it difficult to justify taking money from a 401(k) for anything but retirement.
A retirement account is a long-term investment, he says, and taking money out prematurely means you’re missing out on the opportunity for continued growth.
You’re also paying interest on your loan, although it’s usually at a modest rate.
MarketWatch reports that plans usually set a default interest rate that’s about 1 or 2 percentage points above the prime rate. That means those who have borrowers who don’t have good credit could pay less interest with a 401(k) loan than they would if they took out a loan from a third-party lender.
Still, unless your situation is so dire that it prevents you from having “a roof over your head and food on the table,” Sickle doesn’t advise taking out a 401(k) loan.
What Happens When You Take Money From Your 401(k) Early?
It’s important to note that a 401(k) loan is not the same thing as a 401(k) hardship withdrawal.
A loan is a set amount of money you take out of your account and promise to pay back; a hardship withdrawal is money that you take out of the account preretirement and don’t have to pay back.
While 401(k) loans are generally easy to obtain (there aren’t many requirements or specifications as to what you can use a 401(k) loan for), hardship withdrawals are much more regulated by the IRS. Only certain situations, such as down payments for houses, funeral expenses, medical expenses and more are grounds for taking out a 401(k) withdrawal.
If you end up withdrawing money from your 401(k) early — before age 59 ½, although there are some exceptions — you’ll owe income tax on the amount you withdraw and pay a 10% penalty.
If you leave your job for any reason, you’ll likely have to repay your loan within 60 days — otherwise, it is considered an early withdrawal and subject to income tax and the 10% penalty. Same goes for if you don’t make a payment for 90 days.
Why it Could Get Harder to Borrow From Your 401(k)
The Wall Street Journal reports that many employers see 401(k) loans as a major risk to the ability of their employees to retire (and make way for younger employees who work for less pay). Many companies are taking steps to make it harder for employees to borrow from their 401(k) plans.
These precautionary steps include requirements that employees wait 90 days after repaying a 401(k) loan before taking out another one or meet with a financial counselor before borrowing from their retirement accounts.
Alternatives to 401(k) Loans
After reading about 401(k) loans, you might be feeling a bit uncomfortable with all of the risks and contingencies.
If you’re still in a bind and are considering taking money out of your retirement account, check out our article about ways to avoid penalties when you take money out of your 401(k).
If you’re still wondering about your options when it comes to taking out a loan of any type, check out our article about the best and worst ways to borrow money.
Another option? If it’s not an emergency, hold off on the purchase. If you don’t have the money now, it might not be a good time to make it.
This article contains general information and explains options you may have, but it is not intended to be investment advice or a personal recommendation. We can’t personalize articles for our readers, so your situation may vary from the one discussed here. Please seek a licensed professional for tax advice, legal advice, financial planning advice or investment advice.
Kelly Smith is a junior writer and engagement specialist at The Penny Hoarder. Catch her on Twitter at @keywordkelly.