Should you loan money to yourself?

[Mar 13, 2011.]

 

Almost every financial expert out there will tell you that taking a loan from your 401(k) is a bad idea. But what should you do if you've exhausted all other options for borrowing money and don't want to turn to payday loan shops? There are pros and cons to consider about 401(k) loans.

Pros of getting a 401(k) loan

When you borrow money from a 401(k)retirement account, you are making a loan to yourself that has to be repaid with interest, according to a SmartMoney report. But unlike getting a personal loan from a bank or other lender, all interest paid on a 401(k) loan goes to you. The interest rate on 401(k) loans is generally less than what credit card firms or payday loan shops charge.

Another thing that works in your favor with getting a loan from your retirement account is that the application process is much easier than going to a lender. Credit card firms and banks will scrutinize your credit score and financial history before approving you. Applying for a loan from your retirement account involves a lot less paperwork and no credit check because the money already belongs to you. There also won't be a requirement for you to put up any collateral.

Cons of retirement account borrowing

Despite the ease of getting a loan from a 401(k) account, that doesn't mean you should do it. Taking money out of a retirement account means that it won't continue to earn interest toward funding your retirement. When you make regular contributions to a 401(k) the twin powers of compounding and dollar-cost averaging both work to help increase the balance.

Borrowing from a 401(k) can also be risky if you end up losing your job. Loans from retirement accounts can usually be stretched out over several years, giving you plenty of time to pay them back. But once your job ends the loan will become due within a shorter time frame, typically 60 days. If you don't repay the loan in that time, the money will be treated as a distribution. If you are under 59 1/2 years old, you'll owe taxes and a penalty.

Tread carefully with getting a 401(k) loan

While a loan from your 401(k) can get you through tough times, there are a variety of factors to consider before borrowing money. Take time to talk with the administrator of your retirement plan and/or your accountant to make sure you understand all the ramifications of getting a loan.

 

About Author:

Francine L. Huff is a freelance journalist and the author of The 25-Day Money Makeover for Women. She has appeared on a variety of TV and radio shows.