Large Life Purchases: Is Using a 401(k) Loan a Good Idea?

Are you thinking of making a big purchase, like buying your first house, but uncertain how to fund a down payment?

If you haven’t been able to save enough to swing the costs for a big purchase—something that might require tens of thousands of dollars—what are your loan options?

If you have a 401(k) with a sizable balance, you could consider taking out a 401(k) loan. But before you do that, be sure to weigh the potential benefits and costs of tapping your retirement account.

Everyone’s situation is different, but here are some general tips to help you if you want to start thinking about taking a 401(k) or a 403(b) loan.

Know the Terms

Josh Alpert, owner and president of Alpert Retirement Advising in Southfield, Michigan, says there are two reasons why most people take a 401(k) loan: to fund a big life purchase, or because they’ve had some sort of hardship and need access to cash. He says in general, a loan can be up to 50% of the vested balance, as much as $50,000.

There are pros and cons to taking out a 401(k) loan for a major life purchase. Alpert says two of the biggest pros are that the money is easy to access and there’s no credit check needed. “You don’t have to go through a bank, and it’s a quick process. Once you’ve drawn out the money, you have about a five-year period to pay it back,” he says. And if you borrow to purchase a home, that five-year period can be stretched, he says.

Borrowing from Yourself = Paying Yourself the Interest

Loan rates can be low. According to 401khelpcenter.com, many loans are calculated by using the prime rate, plus 1%. Because it’s a loan, as long as you keep current on the payments, it’s not subject to the 10% penalty for early withdrawals (see Avoid Missed Payments below). And, unlike when you borrow money from a bank, you’re paying the interest to yourself, which might make those interest payments a bit more palatable.

But you can’t just smash your 401(k) piggy bank, take the money, and think you’re done. There are 401(k) loan rules that must be followed to avoid hefty penalties. And there are downsides to taking a 401(k) loan.

Watch those Fees, and Avoid Missed Payments