If you didn’t know that you can borrow from your 401(k), all of this will be new. But if you did know you had the option, you still might be wondering when it’s a good idea to borrow—or if it’s ever a good idea.
How It Works
If you have a 401(k), you’re allowed to borrow the lesser of $50,000 or 50 percent of the fund’s total amount. In most cases you have to pay the loan back within five years. And even though it’s your own money, you’re required to pay yourself interest—normally a point or two higher than the prime rate.
According to critics, the answer to our titular question is an easy one—never. They argue that there’s an opportunity cost to borrowing from your 401(k) that outweighs the rewards. Specifically, when you withdraw money from your 401(k), it no longer has any earning power. Money can’t work for you if it’s not invested, and for the majority of Americans who are woefully behind on retirement savings, that’s a big deal. There are other reasons experts point to that make it a bad idea, but that’s the cardinal one.
Not So Fast…
Other experts say that there are plenty of reasons to borrow from your 401(k), and that the consequences aren’t as negative as some people think. For example, the fact that you’re paying interest on the loan means that you’re not losing all of the earning power of the money. If it’s earning interest, your money is still working for you.
Important Purchases Only
Most experts agree that a 401(k) should be used for emergencies or important purchases only. Paying for a costly home repair that cannot wait could be a good reason. But purchasing a pool and hot tub for the backyard? Not so much. Exhaust every other effort to get the money before tapping your 401(k).
If you are going to borrow, be absolutely certain that you can pay back the loan in five years. If you can’t, you’re going to pay taxes and penalties that come with withdrawing money before the age of 59½.
A Down Market
If the market were to fall for an extended period of time, you might actually make money on the loan, because the interest payments could be larger than the overall loss of value from a market downturn.
Borrowing during a recession may not be such a bad idea, because instead of the money losing value, it’s still gaining it in the form of interest payments. Coincidentally, the time when a lot of people run into money problems is during a recession, when sudden job loss is more common. On the other hand, if the person losing the job is you, you will likely have to pay back the entire balance of your 401(k) loan within 60 days or be subject to penalties.
The Lowest-Cost Loan
If you’re going to borrow money anyway, taking it from your 401(k) might be the best deal, especially if your credit is damaged. With payday loans well into double- or triple-digit annual percentage rates, that 401(k) interest rate becomes extremely attractive. Even regular consumer loans will cost more than a 401(k) loan.
Around nine percent of recent home buyers borrowed from their 401(k) or another pension plan to cover the down payment on a home. Other than it being a cost-effective lending source, another advantage is that most employers will give you five to 15 years to pay back the loan when used to help finance a home.
A loan for smaller medical bills could count as a good reason to borrow from your 401(k), but only if you have contacted the medical facility and tried to work out a payment plan. You still have to pay it off at the end of five years. But if you do have to pay taxes on the loan due to your not paying it back in time, there is no 10 percent penalty.
Proceed with Caution
Expert still generally agree that borrowing from your 401(k) is a bad idea, but there may be some situations in which it makes good financial sense. That said, very few reasons fall into the “good financial sense” category, so proceed with caution.