Many 401(k) plans allow participants to take out a loan against their holdings, so long as they pay it back with interest over time. And while there are some completely valid reasons for doing this, a lot of people take out 401(k) loans for the wrong reasons.
Source: 401kcalculator.org via Flickr.
According to a recent study (link opens PDF) conducted for Schwab, nearly one-fourth of 401(k) participants have taken out a loan from their plan, for reasons that range from putting a down payment on a house to simply paying for a vacation.
Let's go over the six most common reasons why people take 401(k) loans and whether they are good or bad reasons for doing so.
Paying everyday bills (24% of 401(k) loans)
It was a surprise to me that the most common reason people borrow from their 401(k) accounts is to pay for everyday expenses, such as recurring bills, groceries, and other necessities.
This is by no means a good reason to borrow against your retirement savings. Basically, for an expense to be a good reason to borrow, it needs to improve your financial situation more than leaving the money to compound in your account would. (We'll get to some situations where this is the case.)
To make sure you never need to borrow for the bare necessities, make sure you have an adequate emergency fund to help cover the bills if times get tough. Or, if you're employed and are having a tough time paying everyday expenses, it might be a good time to take another look at your budget and see where you could cut back.
Down payment on a house (23%)
This can be a good reason to borrow, especially if you are currently a renter looking to buy your first home.
Again, the expenses you borrow from your 401(k) for should be able to earn you at least as much as leaving the money invested. Well, by borrowing to buy a house, you put the power of leverage to work for your finances.
For a simplified example, consider a $100,000 "starter home." In a healthy real estate market, home prices can be expected to rise by 3% to 4% annually, so to be conservative, let's say the house will increase in value by about $3,000 per year.
Well, if you put only 20% down, or $20,000, that $3,000 per year in appreciation is really a 15% annual return on your initial investment. Of course, in some years the value may go up more than that, and in other years it could go down, but over the long run you'll likely come out ahead.
Home improvement or repairs (19%)
This can be a good idea, especially if the repairs add more value to the home than they cost, or if you're trying to sell the house and the repairs make that easier.
However, do your homework and know what you can expect to get in return for home upgrades. For example, using the money for a swimming pool is a poor investment choice. You'll be lucky to recoup 50% of the cost to build the pool, and in some markets it can actually hurt your chances of selling.
On the other hand, replacing worn-out siding can add nearly as much value to your home as the cost of the upgrade, and it can make your house much more attractive to buyers.
Medical expenses (13%)
Whether or not it's a good idea to take out a 401(k) for medical expenses comes down to the individual's situation. Everyone should have an "emergency fund" to cover unexpected expenses. However, some medical expenses can be huge, and borrowing from your 401(k) may indeed be a safer option that gutting your emergency fund.
Buying "something special" (9%)
This is almost never a good idea. If you've had your eye on, say, a new boat, and would need to tap into your retirement savings to buy it, you really can't afford it in the first place.
Your 401(k) shouldn't be thought of along the same lines as a savings account, at least until you're actually retired. Treat the money as if it is untouchable until then, unless an actual emergency or other valid expense comes up.
Paying for a vacation (7%)
This is also a bad idea for the same reasons mentioned in the previous section. If you need to tap into your retirement savings to finance your family's trip to Europe, it's a trip that's probably best saved until you actually retire. After all, that's why the money is there -- not for you to live it up now.
How much does it really cost?
As mentioned earlier, when you borrow from your 401(k), you'll be expected to pay it back with interest. The exact terms vary depending on your plan, and some 401(k) plans don't offer loans at all (they aren't legally required to). However, four- to 10-year terms are common, and interest rates are generally comparable to mortgage rates.
An example is a $50,000 loan to be paid back over four years at 4.25% interest. If you get biweekly paychecks, this works out to about $566 per check to repay yourself. And you don't actually make payments; rather, your repayments are withheld from your paychecks until you've paid yourself back.
Still, the highest "cost" may not be the payments and interest themselves, but rather the investment returns you're losing in the meantime, which are likely to be better than the interest you pay yourself.
The bottom line
This is by no means a full list of reasons for taking out a 401(k) loan, and there are a lot of unique circumstances that could make borrowing from your retirement seem like a priority.
Generally speaking, anything that will improve your financial situation (like buying a house or improving your home) or keep you from going deep into debt or gutting your emergency fund (like medical expenses) is a pretty good reason to consider borrowing from your 401(k) if, and only if, you don't have an alternative means of funding.
Remember that the money in your 401(k) is there for your retirement, and respect that fact when you decide whether to borrow from your account.
