What can you do if you need cash, don’t have adequate savings, and taking out a loan from a bank or friend isn’t an option? What if you are trying to buy your first home and are coming up short for the down payment? Many people turn to a 401k loan, that allows you to borrow the money you’ve already invested.
While it is your money, it is important to note it takes people about three weeks to receive their loan. Plus, before you can get a loan it has to be approved by both your 401k provider and your employer. So if you need money right away, this might not the best option for you.
Additionally, since this is a workplace benefit offered through your current employer, it’s not wise to take out a loan if you plan on leaving your job in the next few years. Here are some things to think about:
1. Personal vs. residential loans
A residential loan can be used for purchasing your first home or primary residence. Your employer and even the IRS may be more lenient with this type of loan and give you up to 15 years to pay it back.
A personal loan can be used for almost anything, including student debt, a new car, healthcare expenses, etc. You may only have five years to pay off a personal loan.
No matter what type of loan you take, the minimum you can withdraw from your 401k is $1,000, and the maximum is half of your current balance or $50,000.
You may be thinking, why do I have to pay interest on a loan I took from myself? The IRS wants you to pay interest to mimic the gains your 401k could have made if the money had stayed invested. Your interest rate is calculated by taking the prime rate – the interest rate that banks charge to their most credit-worthy customers – and adding 1 to 2 percent, depending on your provider.
In addition to paying your interest, you will pay some hefty fees. If you are taking a five-year loan, you could pay upward of $500 in fees on top of what you initially borrowed. Why?
First, there is likely an administration fee (sometimes called an “origination fee”) that goes toward drawing up your paperwork, writing the check and transferring your money. After that, there is an annual administration fee to cover the maintenance of your loan.
4. Repayment schedule
Loans are repaid the same way you contribute to your 401k – automatically and through your paycheck. Since this is a workplace benefit and not built to be easily accessible, most providers will only let you have one active loan at a time. This means you need to completely pay off one loan before taking out another from your 401k.
Defaulting is when you can’t make your loan payment when it’s due. Like any default, this can have serious financial implications. How can you default if your repayments come directly from your paycheck? One way is if your employment is terminated and you are no longer receiving a paycheck. If that happens, you are required to pay back the full amount of your loan within 60 days, and on top of that, your balance will be taxed and you could even face an early withdrawal penalty if you are under the age of 59 ½.
6. Loan modeling tools
This resource from Bankrate allows you to see how a 401k loan will impact your paycheck and retirement plan. Most importantly, make sure you are prepared for a lower monthly income so you can stay on track to meet any long-term financial goals.