If you're suddenly in need of money, you might think about borrowing from a 401k but that's often a bad move. In general, taking a 401k loan is a bad idea, but there are a few circumstances in which it makes sense to do so.
Plenty of people are taking out 401k loans. According to a 2015 report from Fidelity Investments, about 22% of employees had outstanding 401k loans -- with that level representing the lowest level in five years. Let's review four reasons not to borrow against a 401k, along with two reasons to do so.
Five reasons not to borrow
Here are some key reasons to leave those funds in your account:
- The loan terms can be unfavorable. To begin with, there are likely to be a lot of fees attached to the loan. Once you get the loan, keep in mind that the majority of 401k loans have a maximum payback period of five years, which is very short. Exceptions to the five year limit can be made for employees serving in the military or taking a one year leave of absence. The loan term may also be longer if the loan is used to make a down payment on a house. On top of this, the amount you can borrow is limited to half of your account balance, with a cap at $50,000 regardless of balance. Additionally, many 401ks have terms that prohibit you from making new contributions to your account until the loan is paid off, which hurts your retirement funds.
- Your retirement will suffer. Borrowing from a 401k means removing a chunk of money that was previously growing in the account and causing your retirement nest egg to take a hit. Imagine that you withdraw $15,000 of your $30,000 from your 401k, and you pay it back in five years. At the end of five years, you still only have $15,000 in your account. Now, if the $15,000 had stayed in your account and had been invested in the stock market such that you earned an average of 10% annually, then the whole $30,000 would have grown to $48,000. That's a difference of $33,000. Because of compounding interest, you lose even more in the long-term since you only have $15,000 to invest at the end of the 5 year period instead of $48,000. See? It can be a significant setback. It can be especially damaging if you borrow an extra large sum for an extra long period, such as for a down payment on a house.
- Your paycheck will suffer. When you borrow against a 401k, repayments will often be automatically deducted from your paycheck. It's worth crunching some numbers to see how much less you'll be taking home each pay period, and if you can get by on that.
- If you lose your job, you'll have to cough up funds fast. If you borrow from your 401k and then lose your job, you may have to repay that money within 60 to 90 days, which might be much sooner than you had planned to. Before borrowing from a 401k, give some thought to how secure your job is. Might layoffs be happening in the near future? Have you been underperforming or battling a boss? Having this debt might also have you feeling shackled to your current job, keeping you from acting on some promising new job possibilities if you might feel unable to repay the loan quickly.
- There may be a penalty. If you just can't repay the loan, it will be considered an early withdrawal and will trigger a 10% penalty if you're younger than 59 1/2.
Two reasons to borrow
Two times when borrowing against a 401k can make sense are when you need a short-term cash infusion for something crucially important or when you need money urgently and have no better option.
If your need is truly short term, such as a year or less, then you won't be interrupting the growth of your retirement account too badly. You won't lose out on a lot of contributions to the account, and you'll only lose a year's worth (or less) of growth for the funds you withdraw. Just don't borrow the money for something frivolous or discretionary, such as remodeling your kitchen. The need should be vital, such as to cover healthcare costs or to pay for your housing.
If your need for cash is longer term, you may be able to justify borrowing against your 401k if you have no better option. You might be able to borrow from a bank; but if you're only being offered steep interest rates, that can damage you financially, too.
Remember, though, that many financial crises can be mitigated with a little negotiation. Before you borrow against a 401k in order to pay utility bills or pay off credit card debt, try calling your creditors and explaining your situation. See if some arrangement can be made to help you get your finances in order again.
Don't get yourself into a situation where you need to borrow from your 401k. If it happens, make sure that it's your only option and make paying that money back a priority. Don't compromise your financial future to meet a need today.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.