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Understanding the Risks: Is Borrowing from your 401(k) Ever a Viable Option?

Posted by : Premraj | Posted on : Monday, October 10, 2016

Pros and Cons

There are many times in life when you need to get your hands on extra cash, Whether you’re placing a down payment on a house, need to buy a new car or just want to finally take you dream vacation, borrowing money can be a daunting task.

But you may not have to subject yourself to the rates of dangerous payday loans or even the traditional personal bank loans.

If you are one of the forward-thinking people that have a 401(K) account, then you have a possible way to borrow money at a great rate. These retirement funds that are offered by many employees are not only a great way to save for retirement, but may also serve as a loan source if the options are right. Here’s the important things to know about a 401(K) loan:

What is a 401(k) Loan?

A 401(K) is a retirement account that you contribute to with every paycheck. You can put any amount of money you want into it (with certain limitations) and, if you are on a good plan, your employer may even match you, giving you free money. You can contribute before or after taxes are taken out, but the general accounts are the same.

A 401(K) loan is a loan that you borrow against the amount of money in your account. After you’ve had the account for five years, you can typically borrow up to half of the amount you’ve saved, or $50,000, whichever is lower. You are required to pay it back within five years, but you may be able to extend that length if you are purchasing certain items, like a home.

How Do You Pay it Back?

You pay the loan back the same way you contributed to the account in the first place, with regular payments from your paycheck. There are some rules that you must follow or you will be penalized. While many financial planners may consider this type of loan safe, there can be consequences.

First, you need to start making payments after 90 of the loans. This is important because if you fail to do so, the loan will be treated as personal income and will be subject to tax. And, if you are under 59 years old, you will be subject to a 10% penalty on all of the money you borrowed.

You should go over all of the possible penalties before you sign the loan. If you are a Federal employee, you can get a lot of information from My Fed Benefits. If you work in the private sector, make sure you talk to you company’s accounting department for advice.

The Pros

Now that you know what a 401(K) loan is, you need to decide if it’s a viable option for you. Here are some of the great things about a 401(K) loan:

The biggest pro on borrowing from your retirement account is that it’s already your money, so there won’t be any high interest rates to worry about. Sure, you will pay a little interest, but it can be pennies-on-the-dollar when compared to traditional loans.

Also, you don’t need to get bank approval to borrow the money. This means that you can usually get the money very quickly and without the need for a credit check. This is a major plus to many people who borrow. And, as mentioned before, it’s easy to repay the loan: you just use your regular contributions until the loan is paid off.

The Cons

There are some very real cons that you should be aware of before taking a 401(K).

The reason you have the 401(K) account in the first place is to save for retirement. Borrowing money from the account directly contradicts this principle. For the entire life of the loan, you will no longer be increasing the amount of money you’re saving, essentially putting your retirement savings on standby until the loan is paid.

You may also find yourself in real financial trouble if you are ever fired or laid off. If you have a 401(K) loan through your company and you are let go, then you only have 60 days to repay the entire amount. If you borrow a large chunk of money this can cause serious financial hardships.

A good 401(K) account is a great way to plan for the future, and although you may sometimes need money quickly, you need to make sure that borrowing against it is worth it.

Hannah Hayes is a personal finance consultant. She writes about a range of personal finance topics for an online audience. Outside of work she is married to her childhood sweetheart and has a 2 year old son; they’re very content playing happy families at the moment!

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