If you have a 401k, borrowing from it may seem like an easy way to pay off your other debts. However, whether borrowing from your 401k is in your best interest depends on a variety of factors such as interest rates, the rate of return on your 401k, and how stable your job is. Read on to learn more about the pros and cons of borrowing from your 401k to pay off debts.
(Find more tips and strategies on paying down or managing high debt.)
Benefits of Borrowing from Your 401k
Below are some of the benefits associated with borrowing money from your 401k to pay off your other debts.
Since it’s your money, borrowing from your 401k is usually simpler than trying to get a loan from another source. In most cases, you can arrange a 401k loan by calling your firm or 401k provider, or submitting a short application.
Better interest rates
The interest rate on a 401k loan depends on the terms of your plan. However, it is normally only slightly higher than the prime rate, which can be relatively low compared to most loans. This means that if you need the money to pay off a high-interest debt, it may be an attractive option. But keep in mind that when you pay interest on a 401k loan, you are essentially paying interest back to yourself. As a result, if your 401k usually has a high rate of return, the interest savings may not be enough to justify the reduced return on your account.
Why Borrowing from Your 401k May Not Be in Your Best Interest
While borrowing money from your 401k has its advantages, it also has many drawbacks. Below are some of the main reasons why borrowing from your 401k to pay your debts may not be a good idea.
Your 401k is essentially an investment account. Depending on your preferences, the money in your 401k is usually invested in various stocks, bonds, and mutual funds. When you borrow money from your 401k, you are no longer receiving a return on your investment other than the interest you pay yourself on the loan. As a result, if the market is doing well, you may be missing out on big returns on your 401k by taking the money out.
Risks associated with switching jobs or getting laid off
If you leave your job or get laid off, you usually must pay back your 401k loan in full within 60 days. If you don’t, the amount of the loan will be treated as a 401k distribution and considered taxable income. In addition to your increased tax liability, you will also incur early withdrawal penalties if you were not yet allowed to withdraw the money from your account.
You may not be able to contribute to your 401k until the loan is paid off
Certain 401k plans prohibit you from contributing funds to your account until your outstanding 401k loans are paid off. This means that your retirement savings will not be growing while you are paying back the loan. Further, since 401k contributions reduce your taxable income, you may be required to pay more taxes.