Taking a loan from your 401(k) is a big decision. It’s your money, of course, but as with many important financial decisions, there are pros and cons you should consider.
Taking steps today to plan for your future financial needs should be part of everyone’s financial playbook. Taking on the discipline of putting aside savings can help bankroll important personal milestones and objectives down the road. And having some extra cash in your bank account is also a great form of insurance against financial emergencies.
The Pros and Cons of 401(k) Loans
Pros: If you decide to take a loan from your 401(k), this loan is tax-free. You can borrow up to 50% of your vested balance—up to a maximum of $50,000—from your 401(k). You’d be paying yourself interest instead of paying a bank. This would save you approximately 4%-7% in interest. The maximum loan term is five years, which gives you time to pay yourself back.
Also, the 401(k) loan does not affect the amount you can continue to contribute to your 401(k). The loan repayment is deducted through your payroll, so it is easy to repay because you don’t have to remember to write a check.
Cons: The primary argument against taking out a 401(k) loan is that it reduces your 401(k) balance. If you take a loan right before a stock market increase, for example, you will not gain as much because the loan amount is not invested. Thus, the loan could significantly hurt the growth of your long-term retirement account. Additionally, if you are taking a loan to buy a home or to remodel one, the interest you pay is not deductible for tax purposes. (For related reading, see: 8 Reasons to Never Borrow From Your 401(k).)
How to Help Prevent Needing a 401(k) Loan
Whether or not you’re currently in the position of needing a loan, why not start protecting against this kind of step? Saving funds in bank or investment accounts for some of life’s great moments is a valuable discipline. These objectives might include buying your first home or dream home, college and wedding expenses for your kids, as well as saving for retirement.
You should also maintain an emergency fund for tough times like medical emergencies for your family and pets or unexpected home repairs. In short, holding three to six months of living expenses in your bank account continues to be a good strategy to be prepared and not have to take funds from your 401(k) plan.
I would also suggest that, if this applies to your goals, you start saving in your bank account for a down payment for a home or home remodel. You can use a combination of savings and bank loans for home remodeling and car purchases. The bottom line is that 401(k) loans are not the ideal source of funding for weddings, vacations or pet medical bills. Sacrificing a portion of your retirement funding should only be undertaken after seriously considering all the future impacts.
(For more from this author, see: What to Do With Your 403(b) Funds if You Change Jobs.)