Borrow Your Own Money? 401k Loans Explained

Is it a good idea to borrow money from your 401k? We explain how 401k loans work so you can better weigh the pros and cons of borrowing your own money.

Dear Dollar Stretcher,
We “borrowed” money from our 401K a few years ago and again just last year. Don’t know if other 401K plans do this – but we are allowed to borrow up to half of the amount in our account with no collateral and make monthly payments at a good interest rate. This means we are actually paying ourselves interest on our own money.

In our experience, we’ve still been earning great dividends in our account while paying on the loans, but I know some financial experts advise against borrowing from a 401k. What are we missing? I guess we’re not seeing any downside.
Lorrie N.

Lorrie’s right. About 75 percent of all 401k plans will let you borrow against your account. And about one-third of people who participate in plans borrow from them. But is it a good idea?

If you ask your co-workers, you’ll find that many of them think so but aren’t that sure how the whole thing works. Let’s try to clear some of the fog.

401k Loans Explained: What You Need to Know Before You Decide To Borrow

Start with some facts. The law limits you to borrowing 50 percent of the account’s value or $50,000, whichever is less, in a 12-month period. Unlike just about any other loan, there’s no credit check. Borrowers have five years to pay the money back. If the loan has been used to purchase a home, the law allows up to 30 years for repayment, but many plans limit the time to 10 years.

You’ll be charged an interest rate that’s considered competitive with other lenders. That’s an IRS requirement. Often, plan administrators set the rate at prime plus 1%.

You won’t pay taxes on the amount that you borrow. Taxes come into the picture if you don’t repay your loan on time. Then, you would pay a 10% penalty as well as ordinary income taxes on the withdrawn money.

Usually, a payroll deduction is used for repayment. Obviously, this makes it less likely that you’ll miss a payment. But it also means you won’t be seeing the money in your paycheck. If you need it for groceries, that’s just too bad.

You’ll also need to remember that you can’t deduct your interest expense on 401k loans. That might make a home equity loan look more attractive.

A caution: some plans will allow or even require that you reduce or eliminate new contributions to the 401k plan while you have a loan outstanding. You might think it’s handy to use that “extra money'” to help repay the loan. But that’s something that you need to consider carefully. For instance, if you’re 30 years old now, every dollar you don’t put in the plan today could cost you $30 when you’re 65.

How Can You Tell If Borrowing From Your 401k Is a Good Deal Financially?

Most people compare the interest rate they’d get elsewhere to the rate offered on a 401k loan. That’s a good place to start. If the rate on the 401k loan is higher, you probably don’t need to go any further.

But, even if you could save by borrowing from your 401k plan, that’s only half of the equation. The other half is comparing whether your plan will be earning less by loaning you money. Remember, this time, you’re not only the borrower but also the lender. A low rate could affect the growth of your 401k.

To check, compare the interest rate you’d be paying on the loan to other investment options in the 401k. For instance, if you’ve been earning 11% within your 401k and your loan would cost 9%, you’d be losing 2% per year within your account.

That might not seem important now. But take our 30-year-old as an example. Suppose he’s borrowing $10,000 and will be paying 9% interest, but he could have earned 11% in another 401k investment option. His 401k balance in five years will be about $1,000 less if he takes the loan. And that amount will be worth about $15,000 when he retires and wants to begin taking withdrawals.

Other Concerns You Need To Consider Before Borrowing

There are other concerns that you need to consider before making a loan. Are you a good credit risk? If you fail to repay, you face three consequences. First, if you’re younger than 59 1/2, you’ll pay a 10% penalty for an early withdrawal from your 401k. You’ll also owe income taxes on money that you don’t have. And you’ll have less money in the plan when you retire.

Another thing to consider is what will happen if you leave your employer before repaying the loan. Many plans give you only 30 or 60 days to repay the entire loan if you leave your job. If you don’t, it’s considered a withdrawal and the taxes and penalties kick in.

Some Tax Issues To Keep In Mind

Finally, there are some tax issues that aren’t obvious unless you think about what’s happening. One of the advantages of a 401k plan is that the money you contribute isn’t included in your income for taxes each year. So, it enters the plan “pre-tax.” All the time it’s in the plan there are no taxes paid on the earnings. Only when you retire and begin to take withdrawals are you taxed at your regular rate.

If you take a 401k loan, you’ll have money deducted from your paycheck. That money will have income taxes deducted before it’s applied to your loan. And then, when you finally retire and take the money out of the plan, you’ll have to pay taxes on that money a second time. Of course, in fairness, if you had taken a regular car loan from your Ford dealer, you would make payments and never see the money again.

• A 401k Loan To Pay Off Debts
• Should You Consider a Personal Loan To Repay a 401k Loan?
• A 401k Loan on the Road to Retirement
• Should You Use a 401k Loan To Finance Home Remodeling?
• Can I Save Money Using a 401k To Purchase a Car?

Reviewed November 2023

About the Author

Gary Foreman is the former owner and editor of The Dollar Stretcher. He's the author of How to Conquer Debt No Matter How Much You Have and has been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com.