Earlier this year, Fidelity reported that the number of 401(k) participants out of the 14.5 million people who have their work plans with the company dropped to the lowest point in 7 years.* However, more than one in five do have loans.
That’s a positive trend, especially combined with the fact that 401(k) balances reached an all-time high at the end of last year. However, it still means over three million workers with Fidelity plans have an active loan in their 401(k).
If you need cash, borrowing from your plan at work may seem tempting. After all, most offer loans of half your account value, or $50,000, whichever is the lesser amount.
But before you jump online to fill out an application, let’s explore the pros and cons.
Pros of Borrowing From Your 401(k)
- It’s easy. Typically, you fill out a form and have the money in a few days. There’s no credit check or drawn-out application process. You usually make payments via payroll deduction.
- It’s competitive. The interest rate is most often low, especially compared to a credit card or unsecured loan. For example, a typical rate might be the prime rate plus 1% – today that’s just 5%.
- The interest goes to you. You keep the interest you pay, not some other lender.
- Its use isn’t restricted. Simply put, you can use it for anything.
- It’s got a definitive end. Most plans allow you to set up your repayment schedule from one to five years (perhaps longer in some situations, for example if you’re buying a home) which can provide the light at the end of the tunnel if you’re consolidating other debts.
Cons of Borrowing From Your 401(k)
- It could reduce what you’re saving. This may be the scariest aspect of borrowing from a work retirement plan. Some plans forbid contributions while the loan is being paid back. Even if that’s not the case, it just follows that those with a loan would reduce or eliminate their contributions during the payback period. Bad idea.
- The bull could pass you by. If the markets go up, you could miss out on the growth your loaned money might have earned. However, if the markets head south, that low-interest rate you’re paying yourself may not look all that bad.
- Job loss requires payback. In most situations, you’re required to pay back the loan within 60 days if you leave the If you’re unable, the outstanding balance could be subject to taxes and early withdrawal penalties.
- It could be habit-forming. While a 401(k) loan may be an appropriate borrowing option in certain situations, you don’t want your 401(k) to become a piggy bank. It’s intended for retirement, your emergency fund (hopefully) or other savings should cover shorter-term needs.
- It doesn’t fix the core issue. If you’re using a 401(k) loan to pay off other debts or extend your lifestyle it can be a financial disaster. I’ve worked with people who have consolidated their debt only, because they haven’t fixed the reasons they had the debt in the first place, to end up with both the consolidation loan and a whole bunch of new debt they piled on after they “fixed” their problem through consolidation.
An employer plan may be a practical and economic place to access money. However, it’s important not to overlook the potential negatives.
Tread carefully, and don’t lose your retirement savings momentum.