If you find yourself in a financial pinch and need quick cash, it makes sense to take stock of what savings you already have that you can𝔍 use. For many people, that savings is their employer’s 401(k) plan. And while the money is technically meant for retirement, the IRS allows you to borrow from the account without the tax penalties that typically come with taking money from your 401(k).
But a 401(k) loan isn’t right for everyone🅷. It’s important to consider the downsides of a 401(k) loan and whether there’s a better option for your needs.
What is a 401(k) loan?
A 401(k) loan is a loan you can take from your employer-sponsored retirement plan. The IRS lets you borrow the lℱesser of 50% of your vested balance or $50,000. So if your account has $100,000 vested, you could borrow the full $50,000. But if your account has $150,000, you would still be limited to $50,000. One exception available with some plans is if 50% of your vested balance is less than $10,000, you can borrow up to $10,000.
A 401(k) loan isn’t subject to the tax penalties usually associated with taking money from your 401(k) early. However, you 🔴will have to pay interest on the loan and repay it within five years in at least quarterly payments. It also isn’t subject to credit ⛄requirements, like many other loan options.
401(k) loan disadvantages
A 401(k) loan can seem like a great deal, but it also comes with some downsides. First and foremost, you’re taking money out that should be growing for retirement. It’s true that a 401(k) loan requires that you replace the funds, but until you’ve repaid that money, your 401(k) won’t be able to grow and compound like it normally would.
Another disadvantage of a 401(k) loan is what happens if you leave the company or can’t repay the loan. The IRS states that 401(k) loans m🌃ust be repaid within five years. But if you leave the company, you may be required to repay the loan immediately. If you can’t repay the loan, either by the end of the five years or when you leave your job, the loan may be considered a 401(k) distribution and will be subject to income taxes and a 10% early withdrawal penalty (assuming you aren’t 59 ½). One way to avoid taxes and penalties is to roll the loan balance into an IRA before the tax filing deadline for the year the loan would be considered a distribution.
401(k) loan alternatives
Be🎶fore you take steps to borrow from your 401(k), consider the alternatives.
Personal loan
One of the best alternatives to a 401(k) loan is a personal loan. This type of loan is especially beneficial for non-homeowners who don’t have home equity they can borrow against. Depending on your lender and credit profile, you may be able to borrow as much as $100,000💛 and repay it over a p෴eriod of up to 10 or more years.
One of the greatest benefits of a personal loan is that you can use it for just about any purpose. Additionally, personal loans are generally unsecured, meaning you aren’t putting any assets on the line in case you can’t repay your loan. And since most personal loans have a fixed interest rate, you’ll have fixe🥂d monthly paymen🦂ts you can budget for.
Cash-out refinance
When you refinance your mortgage, you take out a new loan with a new interest rate and payment term and use it to pay off your current mortgage. A cash-out refinance is a unique type of refinance arrangement where instead of borrowing the amou🐎nt you currently owe, you borrow more. Then you’re able to take the excess amount in cash.
Using a cash-out refinance has several key benefits. First, because you’re wrapping up the newly borrowed money with your mortgage, you’ll still only have one monthly payment. Additionally, because the loan is secured by your home,🅠 you may get a lower int🍎erest rate than you could get with a personal loan. Finally, if the current market interest rate is lower than your mortgage rate, you have the chance to get a lower rate on your entire loan.
There are a couple of downsides to consider. First, if interest rates have risen since you got your mortgage, you may actually end up with a more expensive loan. Additionally, because the loan is 🐭secured by your home, if you aren’t able to repayཧ what you’ve borrowed, you could face foreclosure.
Home equity loan
A home equity loan, like a cash-out refinance, allows you to turn your built-up home🌄 equity into cash. But instead of replacing your mortgage entirely, you’re taking out a separate loan with a separate monthly payment.
Home equity loans have some notable benefits. As with cash-🐼out refinances, they come with lower interest rates because the loan is secured by your home. Additionally, because the loan is separate from your mortgage, you can get cash from your home without impacting your existing mortgage rate and term.
Tip: Instead of a home equity loan, you might consider a home equity line of credit (HELOC), which you can tap whenever you need 𒅌funds instead of taking out a lump sum at once.
Life insurance loan
Certain types of life insurance plans allow yo🐷u to accumulate a cash value that you can later use. These insurance policies, known as permanent life insurance policies, allow you to borrow against your cash value. You’ll repay the loan, along with interest.
One of the biggest benefits of borrowing from your life insurance policy, like borrowing from your 401(k) plan, is that there’s no credit requirement. When you borrow a personal loan, cash-out ref🍌inance, or another type of loan, you must usually qualify by having a certain credit score and debt-to-income ratio (DTI). That’s not the c💃ase with a life insurance loan.
Borrowing from your permanent life insurance policy could be a good option. However, there are downsides here, too. For example, your death benefit may be reduced if you die before repaying the loan. And if you aren’t able to repay the loan, your policy could lapse altogether. This would leave you without life insurance 🎀and exposed to income tax on a portion of the withdrawal amount.
Balance transfer or 0% credit card offer
Credit cards are notorious for their high-interest rates, which makes them challenging to use for large expenses. ⛎However, a credit card can be an excellent short-term financing option if you qualify for a balance transfer offer.
Many cards offer 0% introductory interest rates for anywhere from six months to two years. As long as you can repay the balance within that introductory period, you can make a large balance transfer or purchase and pay no interest at all. And depending on the credit cards you have, you may even be able to do a 0% balance transfer with a credit c♎ard that’s already in your wallet.
Keep in mind that the 0% APR is a temporary arrangement, meaning, eveꦉntually, interest will accrue. And if you don’t pay off the♎ balance by then, you could end up paying a large amount in interest.
Does it ever make sense to use a 401(k) loan?
If you’re facing a financial emergency or hardship and need quick cash, yo🐈ur first resort should usually be an emergency fund. But if you don’t have an emergency fund, there are plenty of financing options available.
Before taking money from your retirement account, consider wheth𒉰er one of the other options listed above might be available to you. Generally speaking, a 401(k) loan should be your last resort. But if you’ve exhausted other options and still need money, it may be worth speaking with your employer about whether a 401(k) loan is available 🔯to you.