401(k) Loans: Read This Before Borrowing

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Borrowing from your 401(k) may seem like a good idea -- it's cheaper than a credit card, and the interest goes to you, not a bank. Plus, the rules of many 401(k) plans allow loans of up to half of the balance. According to Fidelity, though, borrowing from a 401(k) could lead to trouble.

How a 401(k) loan works

401(k) plans aren't required to allow participants to borrow from their savings, but 87% of U.S. plans do. If loans are allowed, participants may be allowed to borrow up to half of their account balance, or $50,000 -- whichever is less.

A 401(k) loan must be repaid in "substantially equal payments" over a term of up to five years, but longer loan terms are allowed if the money is used to buy a primary residence. Just like bank loans, 401(k) loans are paid back with interest, with the big difference being that the interest is paid to your own retirement account, not a bank. Rates can vary between plans but are generally in the ballpark of the rates you would expect on a 30-year mortgage loan.

Paying yourself back with interest vs. leaving the money alone

A low-interest loan may sound like a smart idea, especially when all of the interest you pay goes right back into your retirement account. However, there's a problem with this, and it's best explained with an example.

Let's say you're 35 years old and you decide to borrow $25,000 from your 401(k) to buy a boat. Your plan charges 4% interest, which translates to monthly payments of $460 for five years, or $27,600 altogether. So you're definitely ending up with more money in your account than you started with.

However, consider that the stock market has averaged historical returns of close to 10% per year. Conservatively estimating your 401(k)'s average rate of return at 7% per year implies that if you had left the $25,000 in the account, it would have grown to more than $35,000 after five years -- by the time you're 40.

Further, the long-term difference can be even more dramatic. Assuming the same 7% average returns, the effect of that $25,000 loan would be $14,360 less in retirement savings at age 65. Most people would agree that's a pretty steep price to pay for a $25,000 loan.

In a nutshell, the money in your 401(k) has greater earning potential if you leave it alone. Over the long run, a small 401(k) loan can make a pretty big difference in your retirement savings.

Other considerations

According to an analysis by Fidelity, 22.5% of 401(k) participants borrow against their accounts, and there are some disturbing trends among members of this group.

First, half of the people who borrow from their 401(k) take out more than one loan over the course of their plan participation. As you might imagine, this can amplify the effects on long-term retirement savings that I described above. Your 401(k) is not a checking account, and it's important not to treat it like one.

Also, many 401(k) borrowers evidently find it difficult to repay their loan and maintain their savings rate. Fidelity found that 40% of borrowers reduce their savings rate, and more than one-third stop contributing to their 401(k) entirely within five years of taking out a loan. If you do decide to take a loan from your 401(k), be sure you can make the payments without sacrificing future retirement investing, which could be catastrophic in the long run.

Should you use a 401(k) loan?

Having said all of that, there are some circumstances in which a 401(k) loan makes sense. For example, if you use the proceeds to pay off high-interest credit card debt, the low-cost borrowing of a 401(k) loan might work out in your favor, even when you consider the long-term effects on your 401(k). If you have $10,000 in credit card debt at 18% interest, you're paying interest at the rate of $1,800 per year just for the privilege of owing money.

On the other hand, with a $10,000 401(k) loan at 4% interest, you'll pay just $1,040 in total interest over a five-year repayment period. And, if you use the interest savings to boost your retirement savings, say in an IRA, it can offset the negative effects of the 401(k) loan and more. Therefore, borrowing from your 401(k) to pay off high-interest debt could be a good reason, if you can't borrow money for a similar interest rate elsewhere.

Broadly speaking, tapping your 401(k) for a non-essential purchase like a boat, vacation, or a shopping spree is generally a bad idea and can be quite destructive to your retirement savings. On the other hand, when it comes to consolidating higher-interest debt or using the funds for another financially advantageous purpose, a 401(k) loan could be a good option, if the loan is your cheapest option for borrowing.

The article 401(k) Loans: Read This Before Borrowing originally appeared on Fool.com.

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