There are several advantages and some potential drawbacks in borrowing from your 401(k) account.
On the plus side:
- You usually don’t have to explain why you need the money or how you intend to spend it.
- You may qualify for a lower interest rate than you would at a bank or other lender, especially if you have a low credit score.
- The interest you repay is paid back into your account.
- Since you’re borrowing rather than withdrawing money, no income tax or potential early withdrawal penalty is due.
On the negative side:
- The money you withdraw will not grow if it isn’t invested.
- Repayments are made with after-tax dollars that will be taxed again when you eventually withdraw them from your account.
- The fees you pay to arrange the loan may be higher than on a conventional loan, depending on the way they are calculated.
- The interest is never deductible even if you use the money to buy or renovate your home.
Perhaps the biggest risk you run is leaving your job while you have an outstanding loan balance. If that’s the case, you’ll probably have to repay the entire balance within 90 days of your departure.
If you don’t repay, you’re in default, and the remaining loan balance is considered a withdrawal. Income taxes are due on the full amount. And if you’re younger than 59½, you may owe the 10% early withdrawal penalty as well. If this should happen, you could find your retirement savings substantially drained.
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