Financial experts generally suggest avoiding 401 (k) loans. There are legitimate concerns that the loan will slow the growth of the pension plan or that a default on the loan will create a taxable event. That said, there may be good reasons to take out a 401 (k) loan. How do you know if a 401 (k) loan is right for you?
Understanding the real cost of a 401 (k) loan
When you borrow on your 401 (k), you are withdrawing some of your savings from the investment market. It has been shown that missing a few days in the market in any given year can be very detrimental to the overall return on your investments. Even when you average the returns on your investment and compare it to the interest you pay back on a 401 (k) loan, you’ll find your hard-earned dollars leaking out of the plan for years to come.
For example, take someone who has a 401 (k) balance of $ 30,000 and borrows $ 15,000. After 5 years of repayment of the loan at an interest rate of 4.5%, they still end up with $ 1,800 less at the end of the 5 years the person who leaves his 401 (k) invested earns 8%. That $ 1,800 not invested over 20 years would equate to over $ 8,000 in lost savings.
Now imagine if that same person borrows from their 401 (k) twice more in their working years. These small leaks of 401 (k) loans could leave them $ 25,000 less in their nest egg. Those dollars could be used to retire months earlier or help pay for health care.
Add in the risk of your 401 (k) loan defaulting due to separation from your business, creating taxes and possible penalties, and it’s easy to see why using a 401 (k) loan ) is not recommended. If this person in the example above leaves their business with an unpaid loan balance of $ 15,000, they will likely have to pay back the $ 15,000 or face income taxes (plus a 10% penalty if they is under 59 and a half). Not only would they have $ 15,000 less saved for retirement, but depending on that person’s tax bracket, a default could create $ 3,000 to $ 5,000 in taxes payable. If they don’t have enough regular savings to cover taxes, they may be forced to withdraw additional funds from their retirement savings, further compounding the loss of future growth.
Consider your alternatives first
401 (k) loans arose out of the need for liquidity. An emergency fund is the best way to avoid a shortage. This is why it is generally recommended to have at least 3 to 6 months of necessary expenditure in savings.
A low interest loan is also a great alternative to a 401 (k) loan. If you have equity in your home, consider a home equity line of credit before you experience an emergency. This can make a lot of sense when financing home renovations.
A low interest or zero interest credit card can be a good way to transfer and reduce credit card debt. Also, you can work with a lender to get a low interest personal loan. Peer-to-peer lending sites like Prosper and Lending Club are relatively new options that can often offer lower interest rates on personal loans than more traditional institutions. If lower cost loan alternatives and emergency savings are not available, here are the reasons to turn to the 401 (k) loan:
Are you looking to pay off higher interest rate debt?
If the interest on your debt is high (almost double digits), the 401 (k) loan can help save you money. Consumer debt can be expensive, especially with credit cards. The average credit card interest rate is 16-18%. With an average balance of around $ 6,500 per card, many Americans pay thousands of dollars in interest if they only make minimum payments.
If you pay just a little more than the minimum on a $ 6,500 credit card, you’ll end up paying $ 4,800 interest over 8 years. By refinancing this same $ 6,500 with a 401 (k) loan, this interest drops to less than $ 1,000 over 5 years. The loan balance is also repaid at the end with the same payment.
Should You Make This Decision To Reduce Your High Interest Debt? If you are committed to permanently paying off your high-interest debt, this can provide you with a cost-effective and convenient way to do so. Just make sure that you also agree not to use and keep any balances on your credit cards. Also keep in mind that 401 (k) loans are allowed for up to five years, so use a calculator to model what is a comfortable payment and only borrow what you think you can repay within that time frame. Once a 401 (k) loan is in place, it may not be easy to adjust.
You need money fast
If you find yourself in a situation where you need cash quickly like a medical emergency and you don’t have access to low interest loans, then a 401 (k) loan can help bridge the gap. deviation in a pinch. Since the loan is secured by your pension plan balance, you are essentially operating like your own bank. It means no credit check. Plus, the loan doesn’t show up on credit reports, so you avoid issues like credit checks and credit usage that lowers your credit score.
If using your pension plan is the only option, then a loan is probably the best way to access these funds.
When comparing a 401 (k) loan with an early distribution of your 401 (k), one of the main advantages of the loan is the fact that it is neither taxed nor penalized. By avoiding an immediate reduction of 20% or more in its value, you leave more money invested for your future. Also, the borrowed amount may need to be repaid while a 401 (k) withdrawal is permanent.
Should you or should you not?
The general policy of avoiding 401 (k) loans exists for good reason. However, it is important to understand all of your options if you are in a situation where you are buried in very high interest rate debt or need funds for an emergency. In the case of a retirement plan loan, follow the steps to calculate the actual cost of the loan and compare it with the alternatives to determine which move is best for you.