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Borrowing money from your 401(k) fund is a quick and easy way to gain access in a pinch to up to $50,000 in emergency cash. But the price of that convenience, in terms of your long-term financial well-being, means a 401(k) loan should be an option of last resort.
Here's the lowdown on how to take out a 401(k) loan, and why you might want to do it (but probably don't).
How Borrowing From Your 401(k) Works
Most 401(k) programs let you set up a loan all on your own, without any assistance, via the website you use to handle other 401(k) tasks, such as changing your contribution amounts and allocating your savings to different investment funds.
Setting up the loan is as simple as finding the loan page on the 401(k) site and specifying the amount you want to borrow. The online form won't let you borrow more than you're entitled to, and interest rate and payroll deduction payments based on a standard five-year repayment period will be calculated automatically.
Once you authorize the loan, the amount of the loan will likely be included with your next paycheck (or placed in your checking account even sooner, if you use direct deposit).
If you have any questions about the process, you'll find an option for contacting fund administrators on the webpage.
How Much Can I Borrow?
The most anyone can borrow from a 401(k) plan is $50,000, but if the total vested amount in your plan is less than $100,000, you can only borrow up to half of that total. One exception in some plans is an option to borrow up to $10,000, even if you have less than $10,000 in vested funds.
Repayment Terms on 401(k) Loans
- You must pay back your loan within five years. You can do so via automatic payroll deductions, the same way you fund your 401(k) in the first place. There is no penalty for paying off the loan sooner than that.
- You must pay interest on the loan, at a rate specified by your 401(k) fund administrator. Typically the rate is calculated by adding one or two percentage points to the current prime interest rate.
Drawbacks to 401(k) Loans
Assuming the loan and repayment process goes perfectly smoothly, there are several major reasons you should think twice before borrowing from your 401(k) fund:
- A 401(k) loan uses money that should be invested and helping accumulate wealth for your retirement. The funds you pull out of your 401(k) cannot gain investment value, and the interest payments you're making to yourself are unlikely to come close to matching the gains you'd make in a moderately successful stock or index fund. (And of course, if you weren't paying yourself back, you could be using what you're paying in interest to increase your 401(k) contribution or invest elsewhere.)
- For most borrowers, retirement savings get put on hold until the 401(k) loan is repaid. Payroll deductions for 401(k) loan repayment typically eliminate or greatly reduce 401(k) payments for the five years (or, ideally, less time) it takes to pay off the loan. Losing five or so years of retirement savings, and likely forfeiting some or all of your employer's matching contributions to your 401(k) in the process, is potentially a huge setback in your retirement savings process. The goal with 401(k) plans, as with all long-term savings programs, is to stash funds in small, steady amounts over long periods of time, and let money accumulate through the power of compound growth and reinvestment. A 401(k) loan disrupts that process in a major way, and most funds can never fully recover.
If your 401(k) loan process doesn't go smoothly, you could face even worse consequences:
- If you lose your job during the repayment period, you must pay back the entire outstanding balance within a grace period specified in your 401(k) loan agreement, or the loan will be considered in default. Grace periods are typically only a few months.
- If you default on a 401(k) loan, the outstanding loan balance is treated as taxable income and will likely increase the amount you owe in federal income taxes.
- Unless you are older than 59 1/2, you also will be charged a 10% penalty for making an early withdrawal from your 401(k) fund on any unpaid portion of the loan.
Will a 401(k) Loan Affect My Credit?
Taking out a 401(k) loan has no direct impact on your credit scores.
- You don't need a credit check to qualify for a 401(k) loan, so taking one out doesn't trigger a hard inquiry and result in a temporary dip in credit scores.
- Payments on 401(k) loans are not tracked by the national credit bureaus (Experian, Equifax and TransUnion), so they do not appear in your credit reports and cannot factor into credit score calculations. If you miss a payment or even default on the loan, your credit scores will not change.
Note, however, that the extra tax and penalty expenses that come with a 401(k) loan default can make it difficult to pay your credit bills, which can jeopardize your credit standing indirectly.
Consider Other Options
Because of the significant drawbacks to borrowing from your 401(k) fund, it's best to consider this option only as a last resort in a financial emergency. Before you raid your 401(k), it would be wise to explore other borrowing options, including personal loans, home equity loans, and even borrowing from family or friends.
If you do end up borrowing from your 401(k) fund, do everything you can to pay the loan back as quickly as you're able. If possible, also try to maintain at least some contributions to your 401(k) during the payback period—ideally enough to get your full employer matching contribution so you're not leaving compensation on the table.