If you hear the words "401(k) loan" and immediately think to yourself "ooh, that sounds like a bad idea", good for you! You're on the right track.
In most cases borrowing from your savings isn't a smart move, particularly when it's from an investment account like your 401(k) that's meant to sit untouched for decades so that it can grow and eventually allow you to retire.
But a 401(k) loan is unique. We covered the ins and outs of how it works in a previous post, but here are the basics:
- The loan comes directly out of your 401(k) investments.
- Repayment is made through automatic payroll deductions.
- Both the principal and interest are paid back into your 401(k), so you truly are borrowing money from yourself.
- The loan is typically easy and quick to get.
The fact that you pay the interest back to yourself is especially unique and makes 401(k) loans attractive in certain situations.
So while you should proceed with extreme caution when considering a 401(k) loan, and while in most cases there are better options available to you, here are three situations in which a 401(k) loan can be a good idea.
1. Increase Your Investment Return
There are certain situations where you can use a 401(k) loan to increase your overall investment return. Here's a hypothetical example showing how it can work.
Let's say that the following things are true:
- Your 401(k) money is invested partially in a stock mutual fund and partially in a bond mutual fund.
- The bond mutual fund currently has an SEC Yield of 1.97%, meaning you can expect about a 1.97% return from that fund going forward (though there are no guarantees).
- You can borrow money from your 401(k) at 4.5%.
Given that scenario, here are the steps you could take to increase your expected investment return while only adding a small amount of risk:
- Take out a 401(k) loan, borrowing money from the bond portion of your account.
- Put the loan proceeds into a taxable investment account and invest it in the exact same bond fund (or something similar).
- You will earn the exact same return on the bond fund as you would have in the 401(k), less the cost of taxes you have to pay on any gains.
- As you pay back your 401(k) loan, the 4.5% interest is essentially a 4.5% return since it's going right back into your 401(k).
In other words, you’re getting essentially the same return on your bond fund in the taxable account, minus the tax cost. But you get a higher return in your 401(k) because the interest rate is higher than the expected return on the bond fund.
And since your bond investment is unlikely to fluctuate too much (though it can certainly fluctuate some), in a worst-case scenario where you lose your job and have to pay the loan back in full within 60 days, you will likely to have the money available to do so.
Here are a few things to keep in mind as you consider this approach:
- The more expensive your 401(k) is, the more likely this is to work out in your favor. That's because you can choose a lower cost bond fund in your taxable account and save yourself some fees over the life of the loan.
- The higher your tax bracket, the less advantageous this is since the tax cost in the taxable investment account will be higher.
- Make sure you're not sacrificing your ability to contribute to your 401(k), and definitely make sure you're not missing out on any employer match.
2. Paying off High-Interest Debt
If you have high-interest debt, taking a 401(k) loan to pay it off could be a good idea.
Before you do so, make sure you've exhausted all other options. Do you have savings you could use to pay it off? Are there any expenses you could cut back on so you could put that money towards your debt? Are there any creative ways you could make a little extra money on the side?
Any of those options are better than a 401(k) loan simply because they don't require you to borrow against your retirement and they don't come with the risks that a 401(k) loan presents.
But if you've exhausted those other options, paying off high-interest debt with a 401(k) loan has two big benefits:
- Your 401(k) loan interest rate is likely lower than the rate on your other debt.
- You pay the 401(k) loan interest to yourself, not someone else.
The big risk you run with this strategy is the possibility of losing your job and having to pay the entire 401(k) loan balance back within 60 days. If that happens and you're not able to pay it back, the remaining balance will be taxed and subject to a 10% penalty. That outcome is likely much more costly than your high-interest debt.
3. Financial Emergency
If you're in a situation where you absolutely need money for something and you don't have the savings to handle it, a 401(k) loan may be your best option.
- It's quick. You can often get the loan with just a few clicks online.
- There's no credit check. You'll be able to get it even if you don't have a great credit history.
- It likely has a relatively low interest rate and you pay the interest back to yourself.
In an ideal world this is exactly what your emergency fund would be there for. But of course life happens and a 401(k) loan can be a good backup plan.
A 401(k) loan should almost never be your first choice. Other than situation #1 above, which should only be done very carefully, in most cases there's another route that would be better.
But in the right situations a 401(k) loan can be helpful and may even lead to better returns. As long as you proceed with caution, it can be a valuable tool in your financial arsenal.