Investors are looking to a new source of cash and it isn’t the credit card. 401(k) borrowing is on the rise as consumers struggle to keep their finances together and their credit card payments current.
The bottom line is that borrowing from your 401(k) plan is a real bad idea. It should only be considered as a last resort. First, let’s take a look at how these loans work. Most plans allow for participants to borrow up to 50% or $50,000, whichever is the highest. Then the loan is typically paid back over a period of 5 years. The benefit that most consumers are drawn to is that you pay yourself back with interest.
Why pay someone else interest when you can pay yourself?
Well, here are the drawbacks for borrowing from your 401(k) plan.
1) You pay taxes twice on the interest that you pay back on the loan
What most people don’t realize about paying interest back to yourself is that when you pay the loan back, you are using money that has already being taxed. A 401(k) plan has pre-tax money in it. Withdrawals from a 401(k) plan are taxed. Along with those taxable dollars is the loan interest that you paid taxes on already. Thus, you will pay taxes on that interest a second time.
2) You borrow once, you might borrow twice
If the 401(k) plan worked out to be a good thing the first time you borrowed from it, well it might become a convenient place to borrow a second time. Your 401(k) should remain sacred and untouched, reserved for your long-term security and not viewed as an ATM machine.
3) If you are laid off, that loan has to be immediately paid back
If you are laid off, the loan comes due. If the loan comes due and you are under the age of 59½, you then pay a 10% penalty in addition to ordinary taxes on the entire amount. That can be very expensive.
I can only think of a few scenarios when borrowing from a 401(k) would be a good idea:
- You are already paying excessive interest rates on current debt outside of the 401(k). A loan from the 401(k) could be a way to drop your interest rate from 30% down to 6 to 7%.
- Prevents you from defaulting on another loan. Remember, you always want to stay current at all costs.
- Borrowing from your 401(k) plan could result in an increased credit score. Moving debt off the books could increase your credit score. By increasing your credit score, you create the opportunity to lower interest rates and refinance that debt and then pay off your 401(k) plan loan.
Copyright © 2008 Prudent Money and Bob Brooks. All rights reserved.
