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Before going too far with the details of what all getting a loan from a 401(k) entails it is important to note that each plan has its own rules, so be sure to read them carefully.
Technically, a 401(k) “loan” is not really a loan – at least not in the traditional sense where a creditor lends to a borrower.
It’s actually an agreement between you and your employer which allows you to tap some of the funds saved inside your 401(k) plan, before you retire or leave the company.
There is no impact to your credit score and no credit qualifications which must be met before borrowing.
The “loan” is secured by funds from your 401(k) plan and payments made are reinvested back in the plan. The idea is for the “loan” to be repaid in 1-5 years (with some exceptions) as if the loan never occurred.
How Long Do I Have to Repay a 401(k) Loan?
That depends on how you plan to use the money. Most 401(k) loans fall under one of two of the following types:
- Conventional (General): May be used for a variety of purposes from medical or educational expenses to paying off high interest credit card debt.
- Residential: Used to fund the down payment on your primary residence.
Conventional loans must typically be paid back within five years, while residential 401(k) loans can be amortized for 10-15 years. Again, check the specific rules for your plan.
What Does It Cost to Take Out a 401(k) Loan?
An important distinction of a 401(k) loan is that the “interest” (remember, these aren’t really loans) is repaid directly to the employee’s retirement plan, with the idea of making the plan whole.
There may be additional fees per plan for the distributions required to fund the loan.
The major cost to consider is opportunity cost. That is, how much would that money have earned had it stayed inside your plan?
Often times the “interest” charged doesn’t quite make up the different; unless you happen to see a down market in the years it takes you to repay the loan.
How Much Can I Borrow?
According to most plan rules borrowers are allowed to request up to $50,000 or 50% of your plan (whichever amount is smaller).
Rick has $130,000 in his 401(k) plan and wants to borrow the maximum amount from his plan to fund college for his kids. He can borrow up to $50,000.
Carl got a later start and only have $70,000 in his 401(k) plan at work. He can only borrow $35,000.
Note, while you can have multiple 401(k) loans, the total cannot exceed the rules stated above.
If you plan to consolidate high-interest debt I recommend first taking an inventory of your debts using something like Personal Capital. Figure out how much you need to borrow to wipe out high-interest debt and only borrow up to that amount.
Should I Take Out a 401(k) Loan?
There are some unique advantages to borrowing from your 401(k), particularly if you have bad credit and/or no home equity in which you could tap as a tax-deductible alternative.
However, there are four important point to consider before getting a 401(k) loan:
- If you leave your employer while the 401(k) loan is outstanding you will owe the full balance of the loan within 60 days of your termination.
- If you don’t repay the loan within 60 days, and you are not at the minimum retirement age for distributions, the loan balance is taxed as an unqualified distribution, which includes your tax rate plus a 10% penalty.
- Since the loan is not reported to the credit bureaus it is not helpful for building credit.
- In a strong market the opportunity costs of removing the money from your retirement plan may exceed the interest you have paid by borrowing the money elsewhere.
If you are interested in a 401(k) loan the best place to start is your company’s Human Resources office or the website for your retirement plan provider (Fidelity, TIAA-CREF, etc.).