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401k Loans - What You Need to Know

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  • 401k Loans - What You Need to Know

    It is your money, after all, and you can simply replace the money through the interest and principal you pay. However, while this option may seem simple at such a time, it's not really as simple when you consider the consequences. For most people, borrowing money from their 401k accounts isn't the best solution at all.

    Rules of a 401k:

    Most 401k plans allow you to take out loans from them, and you are allowed to borrow up to fifty percent of the vested account balance, or $50,000, depending on which is less. You then get a maximum time period of five years within which you must repay the loan. The exception is when you're borrowing this money in order to buy your first home. If this is the case then you have an extended time period to make the repayment.

    It's understandable that in a financial emergency, you most likely only have two options. One is borrowing money from your 401k account and the other is obtaining money through a hardship withdrawal before you reach the age of 59 years and six months. In this case, the obvious answer is to borrow the money, so you should do so by all means. There's no penalty when you borrow money, but there is a ten percent penalty on taking money out of a hardship withdrawal before you are of the specified age.

    What's important is that you realize that there are pros and cons to borrowing money from your 401k account.

    The pros:

    1. There is no need for you to apply for the loan, and you can make all your decisions based on the guarantee that you will indeed get the loan, because there is no credit check involved.

    2. The interest rate is very low. You pay the interest based on the rate that is set by your 401k plan, and it is usually only a few percentage points more than the prime interest rate.

    3. You get a good return. If you have a money market account that earns three percent and when you repay the loan back at six or seven percent, you are earning a profit.

    4. The interest does not incur any taxes. It remains tax-sheltered until you are retired, which is when you remove money from the plan.

    5. It is a convenient option. To borrow money in this way all you need is one phone call, or a short loan form that has to be filled out.

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