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When It Makes Sense to Take a Loan From Your 401(k)

Stocks in this article: MORN

NEW YORK (TheStreet) -- The roof starts to leak, a child needs braces, a spouse loses a job ... At one time or another, nearly everyone has a sudden, unexpected need for cash. And the 401(k) may look like a lifesaver.

Though experts typically caution against taking loans from the 401(k), the strategy has its good points. For one thing, the interest rate is relatively low, often the prime rate (currently 3.25%) plus 1%, and you pay the interest back into the account, not to an outside lender such as a credit card company. So you're really paying yourself. 

You won't have to jump through approval hoops such as a credit or income check, and there are no tax consequences or penalties if the loan is paid back according to the rules. Loans are typically limited to half of the account or $50,000, whichever is less, and the repayment period is no longer than five years.

But on the down side, the loan, until it is repaid, reduces the size of your 401(k) account, cutting your investment returns. That undermines the account's primary goal of investing for retirement.

So when does a 401(k) loan make sense, and when does it not?

"On the scale of most to least attractive sources of emergency cash -- with the most attractive being an emergency fund and least attractive a payday loan -- 401(k) loans rank somewhere in the middle," says Christine Benz, director of personal finance at Morningstar, the market-data firm.

Also see: The New Grads' Guide to 401(k)s

Clearly, a 401(k) loan for a non-essential such as a vacation would be unwise. But, assuming the borrower is disciplined enough to repay the loan quickly, the strategy can make sense for anything from paying down high-interest credit card debt to handling a true emergency such as a medical crisis.

Writing on the Morningstar site, Benz describes four key questions any would-be borrower should ask.

First, can the money get a higher rate of return than it would if left in the 401(k)? Paying off a card debt charging 18%, for instance, would be the same as an 18% return on an investment, because it would eliminate that interest expense. Chances are you could not be certain of earning that much in your 401(k). Of course, it would be foolish to borrow to pay off the card only to run up the card balance all over again. 

Other loan purposes might not offer dependable returns. Home improvements, for instance often do not add as much value to the home as they cost.

Second, is your job secure? If you quit or lose your job, you'll be required to pay the loan back quickly, typically within 90 days, Benz says. If you miss the deadline, the loan would be considered an early withdrawal and you'd have to pay income tax. If you were not eligible for a withdrawal -- generally, if you hadn't reached age 59.5 -- that withdrawal could also be subject to a 10% penalty. To make matters worse, once the loan was considered a withdrawal, you would not be able to get the money back into the account, permanently stunting your investment returns.

Also see: How We Learned to Love Target-Date Funds in a Decade

Third, can you really pay the money back? If you took a maximum loan of $50,000 with five years to repay, you'd be on the hook for $833 a month plus interest -- a lot. Also, it would really be unwise to keep money out of the account for five years, as you could miss an awful lot of investment growth. But paying $50,000 back in two or three years might be awfully hard.

Finally, what will this loan do to your retirement plan? If you paid interest back to the account at 4.25%, you'd earn less than the 7.2% than the average portfolio, balanced between stocks and bonds, earned during the past decade. A younger worker with a 401(k) allocated almost entirely to stocks could easily have averaged more than 10% a year for that decade. In addition, the 4.25% you paid into the account could not really be considered an investment gain because it would just come out of another pocket.

The real damage comes when a loan is taken for the maximum five years, or when the worker raids the account for a series of loans over many years. Borrowing from a 401(k), should be considered only as a last-ditch resort in a true emergency.

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