If you need money and cannot get a loan, due to poor credit, you may consider dipping into your 401k. Many companies allow their employees to borrow from their 401k plans. If you have this option, you may consider taking it. However, is it the best idea? Like most financial choices, 401k loans have their pros and cons. What are they?
The Pros of 401k Loans
No credit check is required. In a way, this is your money. Right now, your company is in control of it. Since the money will eventually become yours, most employers do not have a problem dispensing loans. In fact, they do so without credit checks. Not paying back a 401k loan has many consequences. Due to that fact and the damaging financial impact, most employers know their employees will make good on repayment. That is why a loan is usually offered and without a credit check. If you need money in pinch and have poor credit, borrowing from your 401k may be your only option.
Low interest rates, which you eventually recoup. As previously stated, the money in a 401k plan is yours. Your company is just in charge of managing the funds. For that reason, you are paying interest on your own loan. Not only are you charged low interest rates, unlike the inflated rates for payday loans, you get the money back!
You know what to expect. Your company has as much interest in your 401k as you do. They want to ensure you use the money and properly. For that reason, a company representative will do more than just hand you a check. They will work with you to ensure you understand the process. There should be no surprises. You know exactly how much money you borrowed, how much you need to repay, by when, and the consequences for missing payments. With the recent concern of adjustable rate mortgages, which left many mortgage borrowers surprised and in foreclosure, this should be welcoming news.
The Cons of 401k Loans
Double taxation. 401k plans are tax deferred. Any contributions to your account through payroll deductions reduce your taxable income. For example, if you earn $50,000, but contribute $2,000 to your 401k, your taxable income from the year is $48,000. Unfortunately, that money is taxed when withdrawn. Since you are required to pay that money back, you are taxed again. Why the tax? You are repaying a loan, not technically contributing to your retirement savings.
Many rules and restrictions. For starters, not all employers enable their employees to take a 401k loan. If it is allowed, an application is required. This application is shorter than most bank-approved loans, but approval is not guaranteed. For the most part, businesses prefer to do short-term loans. These loans are typically repaid within 5 years. Car repairs or medical bills are considered short-term loans. Long-term loans, small to medium sized companies tend to stay away from. These expensive loans take much longer to payoff, like home loans.
You can lose money. When working to repay a 401k loan, most employees stop contributing to their fund. Remember, you are repaying the loan not adding more to your account. Although the money is entering back into your retirement fund, it falls into a separate category. If you can, continue to make regular contributions. If you cannot, you miss out of free money from employer contributions.
Fees. You may be charged a fee for requesting a 401k loan. If this fee exists, your employer will determine its cost. On average, it is $50. This fee covers the cost of overseeing of the loan.
As you can see, there are a number of pros and cons to borrowing against your 401k. So, what should you do? If in dire need of money, opt for a loan. Never borrow more than you need, use as a last resort, try to continue with regular contributions, and repay in a timely matter.