If you’ve found yourself in a tight spot and need some money quickly, your 401(k) can provide some relief. But this is a loan with many drawbacks and one that many experts believe should be considered only as a last resort.

Before borrowing from a 401(k), consider these questions:

  • Will you be able to make your loan payment and still contribute to your 401(k) account?
  • Could your credit card spending be curbed?
  • Is your job secure?
  • Can the loan be paid off on short notice if your job is lost? Are the risks of taxes and the early withdrawal penalty acceptable?
  • Are there other ways of getting out of debt? Is it possible to increase monthly payments or get a lower rate for your current loan or credit card? What about cashing in a mutual fund or a savings account?

If you still think your 401(k) is your best option after answering these questions, proceed carefully.

How to tap your 401(k)

Speak with your company’s 401(k) administrator — this person probably works in the accounting or human resources department — to get the specifics on your plan. Or, you can try calling your plan’s toll-free number. Some administrators will quiz you on your need for this loan, but usually they leave it up to your good judgment. Carefully explore all the costs involved and the consequences.

Borrowing from your 401(k) has some advantages:

  • You pay yourself back at a low interest rate, typically 1 percent or 2 percent above prime.
  • Unlike a mortgage, which has recording costs, the transaction costs of borrowing from your plan are generally minimal.
  • There’s no credit check.
  • Repaying the loan through payroll deductions is fairly painless.

You pay yourself back at a low interest rate, typically 1 percent or 2 percent above prime. Unlike a mortgage, which has recording costs, the transaction costs of borrowing from your plan are generally minimal. Plus, there’s no credit check. Repaying the loan through payroll deductions is fairly painless.

In most 401(k) plans, you can borrow up to 50 percent of your vested balance, but not more than $50,000. You have to pay the money back with interest over five years (longer if the loan is for a principal residence).

The good news is that the interest payments are going into your retirement account and not to the credit card company. The downside is that the original contributions to the account were made with pretax dollars, but the loan payments will be made with after-tax dollars.

Below is a hypothetical situation to show the savings associated with using the 401(k) loan at 8 percent, compared with paying off a credit card balance at 17 percent.

You can put together your own table by using Bankrate’s loan payment calculator to calculate the monthly payments. Use the savings calculator to determine the value of the loan payments reinvested over the next five years vs. how the account would grow if you didn’t withdraw money to pay off your credit cards.

401(k) loan vs. credit card repayment comparison
401(k) loan at 8% Credit card at 17%
Loan amount $25,000.00 $25,000.00
Monthly loan payment ($506.91) ($621.31)
Total payments (monthly payment

x 60 months)

$5,414.59 $12,278.86
Interest expense (Total

payments — loan amount)

$5,414.59 $12,278.86
401(k) loan payments reinvested @

10% APR for 5 years

$39,253.63
$25,000 remains in 401(k) earning

10% APR for 5 years

$41,132.72

In this case it makes sense to borrow from the 401(k). You’ve saved almost $7,000 in interest expense and you’ve freed up $115 in your monthly budget that you could use to pay back the loan faster. Put in your own numbers to make the worksheet relevant to you.

Dangers

As a general rule, you should avoid raiding your 401(k) except as a last resort. Think of a 401(k) account as a safe haven rather than an emergency fund. The pitfalls to borrowing are plentiful. They include:

  • Some companies charge fees, including $200 to $400 application fees. And, unlike 401(k) contributions, loan repayments are yanked from paychecks after taxes, not before. The loan is taxed again at retirement when it is withdrawn with the rest of the money in the account.
  • The more money borrowed from a 401(k) account, the less the investment can grow. Things get worse if you try to avoid double deductions from your paycheck by stopping regular 401(k) contributions while you’re repaying the loan.
  • Your job must be very secure. A person with an outstanding 401(k) loan who leaves or is laid off better be prepared to pay up — fast. Most plans require the loan to be paid within 30 to 90 days.
  • If the loan is not repaid, it is considered a default and the outstanding loan balance is treated like an early withdrawal. It is taxed as ordinary income, and a 10 percent penalty is collected if the borrower is under the age of 59 ½.
  • You may take this as an opportunity to run up your credit card balances again. This will leave you in a worse financial situation than before.

Putting money aside for the future requires that you spend less than you make. If you’re not doing that, you need to get to the point where you are. If you’re spending like there’s no tomorrow, then don’t be surprised if tomorrow comes and you don’t have any money to spend.

Lucy Lazarony, Steve Bucci and Amy Fleitas contributed to this story.

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