I occasionally will read and answer financial questions on Quora because I am naturally curious. Plus I enjoy reading about different perspectives that help me stay grounded in reality and how I can best help my readers. A question that I answered recently was regarding taking a 401k loan. Borrowing money from your 401k sounds very tempting especially now that the CARES Act makes it easier to borrow from your 401k. The idea that you are just borrowing money from yourself sounds harmless but it can be very destructive to your financial future. This post will break down how a 401k loan works and why I think it is a bad idea.
How does 401k Loan Work
The 401k is an employee retirement savings plan sponsored by an employer. A 401k loan allows you to borrow the money you have saved from your 401k retirement account instead of a traditional lender. The terms related to a 401k loan are the following:
- 401k loan amount limit up to 50% of 401k balance or $50,000, whichever is lower
- Interest rate for 401k loan is higher than prime rate by about 1 point
- Payments are made directly from your employer paycheck
- Length of loan must be 5 years or less
- Employment termination requires loan balance to be paid back immediately
Related Post: 401k Max Contribution
What is the 401k Loan Amount Limit
The 401k loan amount limit is set to a maximum of $50,000 or 50% of the account balance, whichever is less. However, the CARES Act has increased the maximum 401k loan to $100,000 and removes the 50% ceiling allowing access to the entire 401k balance if necessary.
Given how fragile the state of the economy is in with record-high unemployment, I would be worried about layoffs. Having a 401k loan would require paying back the entire loan balance if your employment is suddenly terminated.
How Long Does a 401k Loan take to be Approved
The process of applying for a 401k loan can take be done very quickly online. However, every employer is different and therefore the loan may require approval from many people such as your HR and the 401k loan provider. Once approved, it will take another few days to receive funds either via direct deposit or a check in the mail.
Does a 401k loan affect your credit score
Having a 401k loan does not affect your credit score. Unlike a traditional bank loan that requires a credit score check, there is no credit check required for a 401k loan. The only requirement would be that you have a 401k balance to borrow from with your current employer. You will not be able to borrow money from 401k balance with your previous employer.
Can a 401k loan be denied
Only an employer can enforce the reasons for a 401k loan since this loan does not originate from a bank. Having good credit is not required for 401k loan approval. However, some employers can restrict a 401k loan for the only following scenarios:
- to pay for education expenses
- to prevent eviction from your home
- to pay for medical expenses not covered from insurance
- to buy a home
Is Taking a 401k Loan a Bad Idea
With record-high unemployment reaching 41 million in the US, many people are struggling financially during this Coronavirus pandemic. To help Americans cope with the financial strain, the US Federal Government CARES Act makes it easier to borrow from your 401k. I would recommend not taking a 401k loan for a couple of reasons that I will explain.
First, taking a 401k loan is risky because your opportunity cost is the potential return on the money. For example, a loan for the maximum $50,000 amount could have returned almost $17,000 after 5 years at a modest 6% simple compound interest. That is an ROI of 34%. Do you think your new investment can do better than 34% after 5 years?
Second, the 401k loan payments are made with after-tax money. Assuming you are in the 24% tax bracket, every $1.00 made after tax is $0.76 into your 401k loan repayment instead of the fully invested $1.00 pre-tax money. After you reach 59 1/2, you pay income tax again on that same dollar so now $0.76 after paying another 24% in tax leaves you with only $0.58. You were just double-taxed on the same dollar just for making a 401k loan.
Quick Summary
To summarize, I would recommend not taking a 401k loan for a couple reasons:
- It will be hard to beat your opportunity cost of 34% ROI after 5 years assuming 6% compound interest.
- You will be double-taxed. First from 401k payments and second when making withdrawals after age 59 1/2.
Have you ever taken out a 401k loan? What was your reason? Let me know in the comments and don’t forget to sign-up for my newsletter.
