4 Key Questions to Ask When Considering a 401(k) Loan

To some investors, the idea of raiding their 401(k) plans by taking a loan is an alien concept--akin to putting salt on a bowl of cereal. 

But the practice is more commonplace than you might think. At the end of 2012, 21% of 401(k) plan participants who were eligible had loans outstanding against their 401(k) plans. And many of these 401(k) borrowers are so-called serial borrowers: Fully 50% of the people who borrow against their 401(k) plans will do so more than once, according to statistics from Fidelity Investments. Not surprisingly, taking a loan from a 401(k) was a somewhat popular move during the financial crisis, with nearly 40% of all 401(k) plan participants borrowing against their balances between mid-2004 and mid-2009. 

Of course, many 401(k) borrowers take out loans because they face imminent financial needs. Debt paydown and handling emergency expenses were the top two reasons for taking a 401(k) loan, according to a survey by TIAA-CREF. 

On the scale of most to least attractive sources of emergency cash--with the most attractive being an emergency fund and least attractive a payday loan--401(k) loans rank somewhere in the middle. In contrast with every other type of consumer loan, a 401(k) borrower pays interest back into the plan, rather than to a third party. The loan doesn't affect your tax bill, assuming you pay the money back in accordance with the loan terms, and you won't be required to undergo a credit check. 

That said, it's a mistake to borrow against your 401(k) balance without fully understanding the terms, the attractiveness of the loan versus other sources of financing, and the ramifications for the rest of your financial plan. 

Here are four key questions to ask before taking a 401(k) loan.

Question 1: Does my intended use of funds promise a higher rate of return than leaving the money be?
When managing your household's finances, it's often helpful to think of yourself as a business owner, seeking out those opportunities that offer you the best return on your investable dollars. Consider your household's balance sheet as a gradation of opportunities, from higher-returning ones to negative-returning ones. Holding a broad portfolio of stock and bond investments will tend to generate a positive rate of return over time, whereas having debt on your household balance sheet generates a guaranteed negative rate of return from the get-go (unless you're taking on debt to purchase an appreciating asset). Taking a loan from your 401(k) lands between the two poles: Yes, you pay interest on the loan, but you pay it out of your own pocket. It's not the same as earning that interest by investing in the market, but it's better than paying the interest to a third party.

Through that lens, you can see that using a portion of a 401(k) balance to pay off high-interest-rate credit card debt may, in fact, be a smart use of your household's financial capital. The investments in your 401(k) would be hard-pressed to outearn what you're paying to service your debt, and the return on debt payoff is guaranteed. Indeed, borrowing against a 401(k) will also tend to be more attractive than any other form of consumer finance, such as a home equity line of credit or home equity loan, because you pay the interest back to yourself rather than to a financial institution.

By contrast, steering borrowed 401(k) funds to an investment with an uncertain payoff, such as starting a business, making home improvements, or buying a home, is less compelling. Even using a 401(k) loan to pay for college is tough to justify from a financial standpoint because the financial benefits of that expenditure will accrue to the child, not the parent, and the parent may well give short shrift to his own retirement plan along the way. Of course, there are many intangible benefits associated with helping send a child to college, but from a purely financial standpoint, using a 401(k) loan to fund college doesn't add up. 

Question 2: Is my job secure?
Taking a 401(k) loan will only beat other forms of debt if you repay that loan on schedule. As long as you remain with your employer, your company will make sure you stay on track by taking the amount you owe, plus interest, out of your paycheck.

However, you run the risk of default if you have a loan outstanding and leave your employer. In that instance, you'll be required to pay the loan back soon, usually within 90 days. And if you can't pay the loan amount back, your loan will count as an early withdrawal and the amount of your loan balance will be subject to ordinary income tax and, if you're under age 59 1/2, a 10% penalty. In short, your once-reasonable borrowing costs will turn nightmarishly high in a hurry. Moreover, by pulling your money out of the confines of a 401(k), which effectively happens when you default on a 401(k) loan, you'll harm your retirement nest egg. You can't get that money back inside the confines of a 401(k), thereby depriving those assets of years of tax-deferred compounding. 

Question 3: Can I realistically pay this back?
One of the big benefits of a 401(k) loan, particularly in this era of stringent loan-underwriting standards, is that there's no credit check. Because you're tapping your own funds, no one is going to deem you unworthy of taking the loan, assuming it's within the limits (usually 50% of your vested balance or $50,000, whichever is less). 

That lack of guardrails puts the onus on you to determine whether the loan is financially viable. Before taking out a loan, carefully consider the effect that repaying the borrowed amount, plus interest, has on your household budget. Although the interest rate on a 401(k) loan may compare favorably with other types of consumer debt, the payback period is likely less generous--five years, in most cases, unless the loan is to purchase a primary residence.

Question 4: Is my retirement plan on track?
Although 401(k) borrowers must pay their accounts back, with interest, there's still the potential for lost retirement savings along the way. For one thing, the interest rate you pay yourself may be lower than what you would have earned had you left the money in your account. The prime rate (currently 3.25%) plus 1% is a common interest rate for 401(k) loans. Even though that rate is low enough to make 401(k) loans affordable for borrowers, it's much lower than the 7.2% return generated by a balanced portfolio during the past decade. And importantly, that interest payment is coming out of your own coffers, not from the market, and it's not tax-deductible. (That tax treatment stands in contrast to the interest you would pay on a home equity line of credit or loan, even though in those cases you're paying the interest to a third party.) As you repay the loan, you may be forced to taper new 401(k) plan contributions. In the TIAA-CREF survey, 57% of respondents who had taken 401(k) loans said they reduced their contributions during the payback period. 

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