You know on an instinctual level that taking money out of your 401(k) is probably a bad idea. Even if you are just borrowing it, you're buying and selling and taking money out of the market in the interim. This is generally not advisable.
However, life being what it is, we sometimes have to choose between the lesser of two evils. So, if you're considering a 401(k) loan, here's what you need to know and the due diligence you need to undertake.
How 401(k) loans work
Each plan has its own rules, so be sure to read them carefully.
Generally speaking, however, you can typically borrow 50% of your vested retirement account balance up to $50,000, and you usually have five years to repay your loan. The nice thing about these loans is that if you stick to the repayment rules, they won't be treated as taxable or show up on your credit record.
Typically, payments need to start within 90 days, and if you leave your job, you'll usually be on the hook to repay the full balance within 60 days (or else risk the loan being treated as a taxable event and subject to withdrawal penalties, depending on your age).
So, should you take the loan? It depends.
First, seek alternatives
Do you have any other source of financing? Home equity, a loan from your family, or similar sources? If any of these options are on the table, be sure to consider them. At the very least, it'll give you an idea of how a 401(k) loan shapes up relative to your other financing options.
If you're dealing with unmanageable debt payments and hoping a loan can help, do yourself a favor and get on the phone first. Call your creditors and see what you can arrange. You'd be surprised at how accommodating lenders -- including credit card companies -- can be in finding ways to make your payments sustainable.
While your 401(k) loan may seem cheap, remember to take the full cost into account.
That cost includes any account returns you're missing out on, any transaction costs involved in the loan, and of course the actual interest you might be paying. If your account isn't doing too well anyway, then the cost of the loan is lower relative to other sources of funds -- this can mean a cheaper loan in a downturn.
Of course, the major risk here is that you don't actually know the true cost of the loan because you don't know how your account will perform. That's important to keep in mind when you're making comparisons to other sources of financing: you might pay a little more somewhere else for a guaranteed price, as opposed to the variable losses from foregone account returns.
And while you might be tempted to think of those foregone returns as unimportant, they do matter: dampening the growth of your 401(k) won't just impact you in the short run, it will persist throughout time. That's because less money invested today means less money compounding tomorrow -- which means less money in the future.
Solve the underlying problem
Finally, if you're taking a loan because you're in a financial pickle, it might present a quick road out of a major bind. However, it won't solve the longer-term problem of how to get your finances under control.
It can be tempting, for example, to think that you can solve a debt repayment problem with more debt, but the fact is that you can't. In this situation you're just postponing the problem -- the debt that you took on to repay your other debt will also need to be repaid one day.
In other words, it's a vicious cycle.
Instead of turning toward short-term fixes, take the time to investigate longer-term solutions. Maybe you need to reorganize your budget, renegotiate your credit card payments, or downsize your life. It's a more laborious and decidedly more painful approach to solving monetary problems, but it's also more sustainable.
Of course, that doesn't apply to every financial situation. Medical emergencies and major financial disasters happen, and in these cases you might find that a 401(k) loan is exactly what you need to stem the tide.
In that case, or in any other, be sure to have an understanding of the rules, repayment schedule, and costs so that you can minimize the downsides of your loan -- and maximize its benefits.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.