The main idea of a 401(k) loan is that it’s taken out against your 401(k) account.
With the money that you borrow, you have your hands untied when it comes to the spending of the money. It can be used for many different things, but what most people use it for are either home repairs, medical bills, or any other unexpected expenses that you might have.
The most significant benefit of a 401(k) is that the money you borrow is not taxed. Besides that benefit, there are other good sides, like not having to pay any interest on the loan.
Even if there are good sides, like with any other loan, there are bad sides to taking out a 401(k) loan.
The biggest flaw of getting the loan is that if you leave your job, you will have to repay the loan within 60 days, or it will be treated as a withdrawal from your account. On top of that, if you halt on loan, you will be subjected to paying the taxes and penalties on the borrowed money.
Taking out a 401(k) loan can be an excellent way to access funds when needed, but it’s also vital to understand the rules before taking one out.
What Exactly Is a 401(k) Loan?
As we already mentioned, a 401(k) loan is a loan that is taken out against the balance of your 401(k) retirement account.
This loan is commonly repaid with the money from your paychecks, and usually, you have up to five years to repay it. When taking out a 401(k) loan, you, of course, have some perks. The first perk is the fact that you will not have to pay any taxes on it. Yet, take bad sides into consideration too.
How Do 401(k) Loans Work?
401(k) loan is not taxable, but you will have to pay interest on the loan. Compared to other loans, the interest rate is much lower, which is another perk. Typically, you can borrow up to $50,000 or 50% of your vested account balance, whatever is less. Once taken out, the loan must be paid within five years, except for purchasing a primary home, where it can be repaid over a longer period.
If by any chance you leave your job, you will have 60 days to repay the loan. If you don’t manage to do it, the rest of the balance will be taxed as income, and you may be subject to an early withdrawal penalty.
Pros and Cons of 401(k) Loans
If you are thinking of getting a 401(k) loan, there are a couple of things to take into consideration.
One of the most significant advantages that this offers is that the interest you are paying on the loan goes directly back into your account. This is a great thing simply because, in the case of an emergency, you can take the money out of your account.
Besides that, you don’t have to go through a credit check to be able to qualify. This can be helpful if you have bad credit or no credit history at all.
There are also some downsides to consider. The biggest disadvantage is that you can’t leave your job. If you do, you will have 60 days to pay the money back. If you fail, it will be treated as a withdrawal from your account, and you will have to pay tax and penalties.
Pros
A 401(k) loan’s biggest advantage is that you can borrow up to $50,000 without going under the credit check. This can be favorable if you have bad credit or no credit history at all.
Another leverage is a very low-interest rate. The interest rate is usually only a few percentage points higher than the prime rate. With this, 401(k) loans tend to be affordable for borrowers.
Lastly, this type of loan is made to be repaid within 5 years or less. This was formed, so you don’t have to be loaded with debt and to be able to pay it off fast.
Cons
The biggest issue of this loan is that you could end up paying a lot more in interest than you would if you took out a traditional loan. It’s because they often have flexible rates that are influenced by market conditions.
Another bad side is that these types of loans have a short period of repayment. Basically, you have higher monthly payments, and if you can’t manage to pay them, it can cause financial struggles.
When Does a 401(k) Loan Make Sense?
This type of loan is suitable for anyone looking for short-term loan with a low interest rate. A lot of people choose this simply since they don’t have to go under credit check, like with traditional loans.
In other words, if you are looking to renovate your house or you may have financial troubles, this is a perfect option for you since you don’t have to undergo a credit check.
Be advised if you are considering taking out a loan to make sure how they work.
Should You Get 401(k) Loans?
401(k) loans have become increasingly popular in recent years, as a lot more people look for ways to approach money in their retirement accounts.
However, don’t forget that there are a few things to consider before taking out a loan. Make sure that your financial plan allows you to get the loan since not all plans do.
As well, think about the interest you will have because even with low rates, you will be paying it back to yourself with after-tax dollars.
With this loan, you will have a time limit regarding your payments. Usually, the given time period is five years, so be sure you can pay it back.
Lastly, you need to be aware of the consequences of halting a 401(k) loan. If you neglect the loan payments, all the money you owe will be withdrawn from your account.
Alternatives to 401(k) Loans
You should consider alternative options as well before making a decision.
Here are a couple of alternatives to this loan:
- Borrowing from family or friends: Compared to a 401(k) loan, this can be a very good option since they can lend you the money interest-free. Make sure you take the loan in writing so there won’t be any misunderstandings.
- Taking out a personal loan: This type of loan usually has a lower interest rate in comparison to credit cards, and it can be a good option if you need to obtain a big amount of money. Remember to look for the best terms and rates.
- Credit card usage: This is the last resort option since credit cards usually have very high interest rates. If you do decide to use this option, try to find a card with 0% APR for a beginning period, so you can save on interest charges.
The Bottom Line
401(k) loan, should you get it or not? This type of loan is very popular these days, and a lot of people are taking it out. Here we discussed the good and bad sides, the benefits it brings, and the rules you need to follow if you don’t want to have financial struggles.
The best perk this loan can offer is that you don’t have to undergo a credit check. You don’t have to have a good credit score or any credit history whatsoever. Amazing option for young people.
Even with that hard-to-resist offer, you should get familiar with the consequences halting this loan can bring you.
Yes, it has very good perks, but in this case, if you leave your job, you will have limited time to pay the loan back. The same goes for not being able to pay it back in time. In this situation, your account goes in minus for the amount borrowed.
Simply said, yes, this type of loan can be very suitable for some people, but for some, it’s not. That’s why it is always best to research and inform yourself more about this before stepping forward and obligating yourself for the next five years or so.
