Hands With Money

Source: flickr user Steven Depolo

87% of 401k plans in the United States offer loans to participants, and they often seem appealing to cash-strapped employees. 401k loans generally come with low interest rates and don't require credit checks, plus you're simply paying yourself back -- all of the interest you pay gets added to your own retirement account. However, before you decide to take out a 401k loan, there are a few things you need to know.

How does a 401k loan work?
If your employer's retirement plan allows participants to borrow against their account's assets (which it's not required to do), the IRS sets guidelines for loan limits and repayment terms.

Under the current law, 401k participants are allowed to borrow up to 50% of their account balance, or $50,000, whichever is less. The loan must be repaid in "substantially equal payments" over a term of up to five years, unless the loan is being used to purchase a primary residence. 401k loans are paid back with interest, and while rates can vary between plans, it generally is similar to mortgage interest rates (in the 4% ballpark, as of this writing).

It's also important to mention that individual plans can set their own 401k loan guidelines as long as they are within the IRS's limits.

Why do people use 401k loans?
According to a Schwab survey, nearly one-fourth of Americans have taken loans from their 401k plans. The most common reasons given for taking the loans were paying everyday bills, making down payments on homes, and making home improvements.

Reason for 401k loan % of loans
Paying everyday bills 24%
Down payment on a home 23%
Home improvements 19%
Medical bills 13%
Buying "something special" 9%
To pay for education 7%
Take a vacation 4%
To start a business 2%
Pay off student loans 2%
Other 21%

Some of these reasons are certainly better than others. For example, it makes more sense to borrow money to fund a down payment or improvement to your home than it does to buy a big-ticket item or to go on vacation.

Consider your other loan options, and then compare the costs and benefits
A 401k loan can be a good way to obtain quick and convenient financing, but it shouldn't be your first choice. Other options to consider include

  • Emergency savings -- If you have the cash sitting in the bank, it's hard to justify a 401k loan.
  • Home equity loan/ line of credit -- If you own your home, look into borrowing against your home equity instead of using a 401k loan. With a home equity loan or line of credit, not only will your retirement savings continue to grow, but the interest you pay will be tax-deductible.
  • Personal loan -- If you don't own your home, or don't have sufficient equity, you should at least look into your personal loan options before deciding on a 401k loan. Check with your bank and with peer-to-peer lenders like Lending Club to see what kind of rates you could get.

Finally, bear in mind that even if you can get a lower interest rate with a 401k loan than with a home equity or personal loan, that doesn't necessarily mean it's cheaper. You also need to consider the missed opportunity cost of the money not being invested in your 401k.

For example, if you can obtain a 401k loan at 4% interest and a personal loan at 7% interest, the decision may sound like a no-brainer -- but bear in mind that the stock market has appreciated at a historical average of more than 9% per year. Taking out a 401k loan will effectively reduce your "return" to the 4% interest you'll pay. So even though you'll save 3% in interest, you could be giving up much more than that in terms of investment gains. I realize that your 401k's performance varies from year to year and is unpredictable, but the fact remains that investments tend to go up over the long run, and you're likely to miss out on some gains by taking a 401k loan.

Respect your retirement
Virtually all of the relevant data shows that Americans aren't saving enough for retirement as it is, so think twice before you decide to borrow from your 401k.

If you need to borrow money for something that will improve your long-term financial situation, and the cost is better than any alternative loan options, a 401k loan may be a decent option to consider. Just keep in mind that the money in your 401k is meant to be used for your retirement, and should be treated and respected accordingly.

Matthew Frankel 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.