The procedure is simple. You fill out a short form, choose which investments to sell to generate the cash and then the money is transferred to your bank account.
Payments are usually made by payroll deduction and the interest rate charged is generally 1 percent higher than the prime rate. Many plans also charge a loan origination fee.
Pros and consThough a seemingly sweet deal, some details within 401(k) loans are not so alluring.
Pros and cons
|•||Pay yourself interest.|
|•||Easy loan application.|
|•||The loan is only temporary.|
|•||No credit repercussions. If you lose your job and default on the loan, it will not show up on your credit report.|
|•||Unlike other loans, the interest payments are not deductible.|
|•||Funds lose out on potential market growth and compounding earnings.|
|•||Taxes and penalties will be due since the loan will be treated as a distribution.|
1. Pay yourself interest. Paying interest to yourself instead of a finance or credit card company would seem to be a big positive. After all, you're the one profiting from the interest.
But, says ING's Reddy, you get into a double taxation situation. While it's likely you are borrowing money that was contributed on a pretax basis, you must pay yourself back with after-tax money.
"Let's say you borrow $10,000 and the interest rate is 6 percent," he says. "The $600 you're paying back to yourself, you've already paid taxes on it. So you had to earn $1,000 to make that $600. When you take it out at retirement, it's probably going to get taxed again. So you're going to end up with around $350 or $400 out of $600," he says.
2. Easy loan application. Some borrowers may prefer to turn to their 401(k) rather than going for a home equity loan, especially since fewer lenders are offering them.
A big plus: The loan application to borrow from a 401(k) is easy and straightforward, plus there is no credit check required.
"You just fill out a form and that's it," says Jay Fik, a Certified Financial Planner and wealth transfer specialist at Consulting Services Group in Tennessee. "You are limited to 50 percent of your vested account balance with a maximum of $50,000, and that is based on IRS guidelines."