Borrowing from Your 401(k) Plan To Purchase a Home
Of the many options you have when you need to borrow money to make a major purchase, borrowing against your 401(k) is one of the more tempting as it can be a relatively simple process. It is actually a fairly common practice, especially when used for the down payment on a house.
Usually you can borrow up to $50,000 or 50% of your 401(k) balance, whichever is smaller. But it it is not without some potential consequences and shouldn’t be a decision made lightly, especially when you need a quick and cheap loan.
Here are the pros and cons of borrowing against your 401(k):
- You can get the loan quickly, usually within a week or so of applying to your company.
- You don’t have to qualify for the loan through a credit approval process because you’re borrowing your own money.
- The interest rate is quite low, usually at prime rate or slightly over prime, so it is relatively low given todays interest rates.
- The interest that you do pay is actually paid back to you and your account.
- You generally have 5 years to pay it back and usually 10 years if you use it for the down payment on a house.
- You are slowing down the growth of your retirement fund. The money you withdraw stops growing until you pay it back, which can have major implications down the road.. Some plans don’t allow you to make more contributions if you have an outstanding loan, which hurts your retirement savings even more.
- You repay the loan through payroll deduction, so the loan will cut down your take-home pay.
- If you leave your job either voluntarily or involuntarily, you have to repay the entire outstanding balance in 60 days or face a huge tax bill. This can be very difficult to do when you are leaving your job, particularly if you are laid off. If you don’t pay it back, the remaining balance is hit with a 10% early withdrawal penalty and you have to pay federal and state income taxes on it that year. So if you had borrowed $50,000 and couldn’t pay it back, you would have to pay a $5,000 penalty and federal and state taxes that could take another $20,000 of the amount.
Borrowing against your 401(k) can make sense as last resort if you need to make a major purchase like a house down payment that you can’t come up with from anywhere else. But consider this step very carefully before you take it.