I previously wrote a post titled “Is It Wise to Take Out a Loan Against Your 401k”.  While I think that explored some of the pros and cons of a using a 401k loan, I would like to add some more material and go a little deeper here.

The conventional wisdom from the “experts” is that you generally shouldn’t take out a loan against your 401k.  This is probably good advice to someone who does not live an intentional life and is not a careful consumer.  However, for someone who is financially savvy, there are many nuances to consider.

There are some people who say you should “never” take out a 401k loan.  I think it is safe to completely disregard someone who says this.  I mean, if you don’t have any money to put food on the table for your child, should you really choose starvation over a 401k loan?  I understand this would be an extremely rare situation, but it is still a situation, which is why the word “never” shouldn’t be used here.

It is important to note that you typically can’t make a withdrawal from a 401k account if you are still employed with the employer that sponsors the plan.  You may be able to take a hardship withdrawal under certain circumstances.  Therefore, if you have not reached the age of 59 ½, sometimes a loan is the only option you have to access “your” money.

If you can take a withdrawal, this may be the best option to take.  There are pros and cons with that too.  But you should know that you will likely owe income taxes, plus a 10% penalty.

Disadvantages

One of the main reasons that you shouldn’t take out a 401k loan is that you will be stuck paying it back, with interest and fees.  Depending on the interest and fees, this could really hurt your cash flow. Sure, you are paying back the interest into “your” account, but you can’t access this any more than you can access the rest of it.

Therefore, the loan is like any other loan in the sense that you have to make payments on it. In most cases, it will come right out of your paycheck, which is really probably a direct deposit.

On this, I am more on the side of the conventional wisdom.  If you are buying a luxury item as a consumer, then you probably shouldn’t take the loan.  If you can’t pay with money already saved outside of a retirement account that you can actually access, then you probably shouldn’t be buying the item. A car or house can qualify as a luxury item because people more often than not get a more expensive car or house than what is really necessary.

The most important thing here is that you shouldn’t take out a loan from your 401k if you wouldn’t take out the same loan from a bank.  You don’t want to put yourself in too much debt.  And a 401k loan is a debt because you have to make payments on it.

In addition, you should consider the fees that your plan may charge.  If you have to pay a large fee or a quarterly maintenance fee (or something similar), then consider if a loan is worth it.  If you are taking a $40,000 loan with a one-time fee of $50, then it is not a big deal.  If you are paying a one-time fee of $50 for a $1,000 loan, that is 5% of the loan right there.  Even if the interest rate is low, that is probably a bad deal (unless it is to put food on the table).

Advantages

So why not just take out a loan from a bank?

The most obvious reason, and perhaps the best reason, is that you pay back the interest into your own account.  Even if you can’t access that money now, you will likely be able to access it when you hit the age of 59 ½, or you can take an early withdrawal (with payment penalty) when you are no longer working for the employer that sponsors the plan.

If you are going to take out a loan with a 5% interest rate, you might as well pay the interest into your own account instead of handing it over to the bank or lending institution. Even if your 401k plan charges a 5% interest rate, and you could get a bank loan with 4%, you may still want to get the 401k loan.

One of the main criticisms of taking out a 401k loan is that you miss out on compounding interest. But this is only correct if your returns are that much greater than the interest rate itself.  And of course, there are no guaranteed returns when it comes to investing in the stock market.

If the interest rate is low, then you are getting a cheap loan.  If the interest rate is high, then you are paying that “return” to your own retirement account for that portion of the money.

I think this is really where the difference of opinion comes in on whether to use your 401k account as a loan source.  People who think you should buy and hold stocks because they historically return an average of 8 to 10 percent per year are not going to favor taking money out.  If I thought I was going to average 8 to10 percent per year in stocks, then I probably wouldn’t want to touch that money either.

But not everyone holds this long-term view, including me.  There is no guarantee that stocks will keep returning 8 to 10 percent every year.  And even if they do, it is a wild roller coaster ride to get that. If I can get a guaranteed return of 5% on a portion of my money, I’ll take it in this low-interest rate environment.  Therefore, if I am going to take out a similar loan anyway, I may as well pay the interest back to myself with the guaranteed rate.

One strategy I have suggested before is that you can actually take out a loan against your 401k to finish off an existing loan.  If you have $10,000 left on a car loan, you could take out a $10,000 401k loan and pay off the balance.  You can make payments back to your account similar to what your remaining monthly car payments would have been.

This could even work for a mortgage if your balance is low enough.  If you have a large balance in your 401k account, you may be able to take a loan up to $50,000.  If you have, let’s say, $40,000 left on your mortgage, then you could pay it off with a 401k loan.  Your cash flow would still be similar, but the interest would be going into your retirement account instead of to the mortgage lender.

I would only implement this strategy if you can pay off the car loan or mortgage in its entirety.

These are some of the considerations when deciding whether to take out a loan from your 401k account.  If you are risk averse and looking for a guaranteed return on some of your money, then a loan may be appropriate in some situations.