Top 3 Risks, 4 Benefits & When is the Right Time to Use Your 401K

By Chika

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Last Updated: September 27, 2021

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Most Americans are heavily in debt.

According to CNBC, the average American has over $90,000 in debt, while the typical American household carries an average debt of $145,000. With the debt levels getting more burdensome for meager income levels, there are few alternatives to lifting this burden. 

Taking a loan from your 401k can be a low-cost way to borrow money to offset your debt. Provided your 401k plan permits loans, it can be a silver lining for those hoping to escape the debt trap. 

However is this a sensible move to make?

If so, when should you consider borrowing against your 401k ? This article highlights some of the benefits and risks of borrowing against your 401k and when you should consider this option. 

 

What is a 401k Loan?

401k loans are loans taken out from your retirement account.

Technically, it is not a loan since the money you're taking is your contribution towards your retirement. It is more aptly described as the ability to access a portion of your retirement fund.

Depending on what your employer's plan permits, you could access up to half of your retirement or a maximum of $50,000, within 12 months. 

 

4 Benefits of Using Your 401k Loan

1. Speed and convenience

Requesting a 401k loan is less cumbersome than applying for other types of loans.

There are no lengthy applications or credit scores to evaluate from lenders. The process of getting a loan takes just a few days.

2. No credit score needed

Unlike other types of loans, eligibility for a 401k loan does not depend on a credit score.

Likewise, when you take out a loan against your retirement account, it does not affect your credit score. 401k loans do not show up as debt on your credit report.

This is a huge contrast to other types of loans where lenders have to confirm your creditworthiness by looking at your credit score. 

3. No prepayment penalty

Though you are meant to repay the loan within five years, there is no prepayment penalty if you decide to pay off your loans early.

This is unlike loans such as mortgages whereby you are charged a prepayment penalty if you want to pay off your loan before the end of its tenor. 

4. Interest payments go to your retirement account

When you take out a 401k loan, the interest paid on the loan goes to your retirement account.

As such, you are merely increasing savings for your retirement account when you make interest payments. 

 

3 Risks of Using your 401k Loan 

1. Could derail retirement plans 

You could be jeopardizing your retirement by borrowing from your 401k to pay debt.

With most companies no longer offering a pension, employees are responsible for their own retirement savings. Your 401k is your safety net for your retirement when you would no longer be able to maintain the same level of productivity.

2. Could lead to a financial mess

If your age is below 59½ years, you would be charged a 10% early withdrawal penalty should you decide to take out a 401k loan. This could leave you in a much deeper financial hole than the one caused by debt.

3. Short term solution to debt crisis

Taking a 401k loan to pay your debt is only a short-term solution to a long-term problem.

It fails to address the root cause of indebtedness but merely postpones the inevitable consequences of poor money management.

 

3 Times When You Should Use a 401k Loan

1. To start a business

 One of the best ways to use your 401k loan is to start a business.

This would increase your cash flow, but also your net worth after the loan has been repaid if done effectively. Also since 401k loans do not have prepayment penalties, you can use the extra cash flow that comes from the business to increase your payment contributions thereby paying off the loan on time. 

2. Home improvement

You can also tap into your 401k to fund the improvement of your home.

While you may have reduced the firepower in your retirement account, the home improvement would increase the value of your home. As such, the money is not lost outright. 

3. Pay off high-interest loans

Paying off high-interest loans with your 401k loan is a good strategy.

Paying off a high-interest loan (like a credit card loan) saves you money in the long term from accrued interest on the principal. It also improves your credit score which can make you eligible for refinancing.

Also, the interest charged on the loan is repaid into the participant's own 401k account, so technically, this also is a transfer from one of your pockets to another, not a borrowing expense or loss.

 

The Bottom Line

A 401k loan may be a way to get cash when you need it, but it is a double-edged sword.

Depending on the purpose, a 401k loan can be used against you. Before tapping into your 401k, make sure that you have a detailed plan on how to repay the loan.

Have a backup plan for repayment if you lose your job during the loan's tenure. Look for and capitalize on opportunities to make extra payments and pay off your 401k  loan ahead of schedule. Remember that your retirement is on the line.

Photo by SHVETS production from Pexels
 

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