When Should You Consider Taking Out a 401k Loan

When Should You Consider Taking Out a 401k Loan

Today’s post is a link to an article I wrote, which was featured on the front page of The Dollar Stretcher. I discussed the topic of taking out a 401k loan — when it might make the most sense and when it is something you should avoid.

I’m including an excerpt below, but definitely check out the full article by clicking here.

Q: What are the main considerations someone should think about when deciding whether to use a 401k loan for home repairs?

DistilledDollar: Understand the full implications of taking out the loan. I’ll walk through the potential value you can access and what the loan terms will look like, including repayment.

Unlike a personal loan or a mortgage, a taking out a 401k loan is taking a loan out against the value of your own assets located within your 401k.

The amount you can withdraw might depend on your individual plan, but the general guideline is that the amount of the loan can be no greater than either:

  1. A) $50,000, or
  2. B) 50% of the value of your 401k

As an example, if your 401k has a balance of $80,000, you can take out $40,000 at most as a loan. If your balance is greater than $100,000, then you are limited to a $50,000 loan.

Repayment terms for a 401k loan involve at least a quarterly payment and the term will typically be for five years. Again, each employer may have differing periods, so always check to see how their options might differ.

To read the rest of the article, check it out by clicking here.

As you can see, this  article is a bit more technical. Sadly, much of the online content talking about people taking out 401k loans seem to end in disaster, so I urge strong consideration prior to borrowing against yourself. Obviously, the safest course of action, specific to home repairs, is to have an emergency fund ready to go.

In our case, we don’t carry much of a cash buffer since we rent (don’t need cash on hand for home repairs) and prefer a bit more of an unconventional approach to our emergency fund.

Share below if you have or know anyone that’s taken out a 401k loan. Did it work out smoothly? Did you know you could take out a 401k loan to begin with?

-Matt
Master Distiller

6 comments… add one
  • Jay Sep 23, 2016, 7:04 am

    Thanks for the breakdown, Matt. While I appreciate that this can be a good way to get a loan in a pinch, I am also a bit wary about employing that strategy. I’m guess I’m a little afraid at the risk of undermining my future self!

    • Distilled Dollar Sep 23, 2016, 9:25 am

      I absolutely agree – express extreme caution when making the consideration. As mentioned, we tend to have a natural tendency to be overly optimistic on our ability to repay a loan AND we tend to inaccurately account for the risks.

      If we need a loan in a pinch, then there are other safer options. If we need the loan or else something catastophic happens (such as a medical bill or bankruptcy), then this route might make more sense than charging up a large credit card bill or any other alternative.

  • Jon @ Be Net Worthy Sep 23, 2016, 8:09 am

    Matt, I’ve used a 401k loan myself and they can be great as long as you use them with caution. In general, I always prefer to borrow from myself than anyone else, which is why I’m also a big fan of HELOCs.

    It was many years ago now, but if I recall correctly, it was about $20k that I needed for a car purchase and the interest rate was better than I could get other places. I reallocated my 401k investments more heavily towards stocks after the loan, since the repayment was basically a bond-type return. I repaid it over two years and it worked out fine.

    • Distilled Dollar Sep 23, 2016, 9:30 am

      That’s comforting to hear Jon! When doing my research, I found a lot more horror stories than success ones.

      I don’t intend to take out a 401k loan anytime soon, but it is helpful to know this option worked for you before. I feel if I’ve contributed to my 401k far and above the average – then it wouldn’t be tragic if I use those funds to shore up enough for a down payment on a future home. Of course, I’ll try to save cash, but it might be something I bring up that could help when negotiating a mortgage. It might also hurt, so I’ll be sure to research more.

  • Atlanta Sep 23, 2016, 1:24 pm

    I took a loan from my 401k to help with a larger downpayment when we bought our first little house and I’ll admit that I’ve regretted doing so. We love the house and it fits perfectly with where we want to be in our lives, but I wish we had waited just a bit longer before buying a home in our area so we could have done it without taking money out of the 401K. Here’s why:

    1) We got the loan because it gave us a cash injection at a low interest rate we would pay back to ourselves. This is great, but ultimately I took $20,000 out of the markets at a young age so my long term gains tied to compound interest will be affected.

    “But I’ll pay it back in just a few short years.”

    2) The above statement is certainly true and I can minimize the impact of it not earning compound interest if I pay it off faster, BUT here’s the catch: I’m paying back pre-tax dollars with post-tax dollars. That hurts just a little bit when you realize that.

    3) It really hurts when you realize the post-tax dollars you’re paying back to the 401K will be taxed again when you do finally retire and start drawing from the account.

    I thought 401K loans might be ok in the right situation, but after my experience I don’t think there’s ever really a right situation unless you ultimately do not have a true emergency fund. I now tell folks that if you ever think you might find yourself in a situation where you need or want to pull money out of a retirement fund, start a Roth IRA so you take out the principal invested. It’s tax free.

    • Distilled Dollar Sep 25, 2016, 2:32 pm

      Those are some excellent points and I hope everyone gets a chance to read your comment.

      If you have a chance, do you mind going into the pros and cons you might have faced if you purchased your home a few years later. You mentioned the missed gains on the equity portfolio, but what would the missed gains have been on the housing front?

      From my perspective, the 401k loan isn’t optimal, but if it the benefits associated with owning a home outweigh the negative costs associated with renting a further two years, then I might have a case to buy earlier. That is a big IF, so I will know more when that time approaches (at least another year away).

      I started my career with investing into a Roth IRA and have since made the transition to only investing into a traditional IRA. 2017 will actually be the first year I will be unable to fund my IRA due to the income limitation so I will be putting money back into the Roth again. You bring up a great point about using the Roth instead of a 401k loan – so I’ll def have to review those options to see if either make sense. I’m starting to think the, “wait a bit longer” approach will be our best bet.

      Thanks again for the detailed comment!

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