Considering a 401(k) Loan? Know These Hidden Dangers

Daniel Penzing
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You Might Reduce Your Retirement Contributions

One of the advantages of loan products, whether you’re looking at a loan for a car, a house, or a business, is that they’re earmarked for specific uses.

You would think that a 401(k) loan would be the perfect way to accelerate your retirement goals.

Because, let’s face it, who wouldn’t want to have their retirement fund double in a year? If you’re in that situation, the best way to solve your problem is to take out that 401(k) loan and pay off the credit card.

But what happens if you take out a 401(k) loan to pay off a credit card loan and then you use that credit card again? The temptation is to say, “No problem! I have a line of credit with my 401(k) for the full amount of the credit card.” And way too many people fall into this very common trap.

You May Earn Less in Your Plan on the Amount of the Loan

The amount that you may borrow in your 401(k) is more than you may think. If you ask for the loan as a lump sum, the lump sum loan amount is the basis for the interest calculation. If you ask for the loan as periodic payments, the 401(k) trustee is required to compute the estimated rate of return on your 401(k) loan that would equal the amount of interest payable on a monthly, quarterly, semi-annual, or annual basis. The trustee is required to choose the estimated rate that produces the lowest number. Based on a January 2011 decision of the U.S. Supreme Court, the estimated rate cannot be less than 6 percent (note that if your plan allows for loans, you may not need to borrow since some plans include an employer match).

The actual rate may be lower than the estimated rate, absent unforeseen events.\

Taxes and Penalties May Apply If You Leave Your Job

You should never, under any circumstance, withdraw money from your 401(k) retirement plan. That doesn't mean you shouldn't take out a loan from your 401(k). There are times when borrowing from your 401(k) can be extremely beneficial and safe, but there are also times when it can end up being an awful idea.

For instance, if you take out a loan from a 401(k), you'll generally have to pay it back with the same money that you borrowed. This is called a vested 401(k) loan, and it's in place to ensure that you don't make a loan from your 401(k) and then decide to leave your company and keep the money.

If you do leave your job and don't pay the full loan amount back, you could face penalties, taxes, and even have your 401(k) benefits lowered.

This type of loan can work great for some people, especially if you have a financial emergency and no other way to pay your hospital bills or your child's college tuition.

But if you're thinking about borrowing from your 401(k) so that you can buy a TV or a car or for any other reason, you need to rethink that decision, because it's probably not worth the risk.

A 401(k) Loan May Have Loan Fees

Generally, 401(k)s contain a long list of fees that are disclosed in the terms and conditions.

Most people reading the fine print of a 401(k) would see the fees and then move on. However, fees can creep up on you without much oversight, if you are not aware of the fees structured into the 401(k).

One such fee often not disclosed is the loan fee. Most people aren’t aware that the money they are borrowing may come with a fee attached.

One study found that about 25% of 401(k) plans charge an administrative fee for borrowers. And most of the 401(k) plans offering loans did not disclose this fee unless you opted specifically for a 401(k) loan.

The fee is relatively straightforward; it is paid to the 401(k) vendor to cover the expenses related to processing the loan.

Most plans charge a percentage of the loan amount.

What kind of fee are we talking about?

The highest fees are charged by 401(k) plans administered by mutual fund companies. These plans are able to charge up to 2% of the loan amount, according to a study of 100 plans by BrightScope.

On the other hand, in plans administered by banks, the fee is lowest at about 0.1%.

Using a 401(k) Plan As an ATM

While there can be some big upsides to taking a 401K loan – namely helping with short term cash flow in an economic downturn – using your 401(k) plan as an ATM is never a good idea. Not only is it a bad idea for the obvious reasons, such as depleting your retirement savings at an accelerated rate, but there are more specific reasons why it’s a bad idea as well.

First of all, the interest rate on your plan loan is going to be far higher than other forms of borrowing – potentially higher than credit card rates. Because of how the interest accrues, this can mean that 401(k) loan interest rates can be well over 20%.

Another big danger – not just to you but to your family – is the loss of your job. If you’re unable to pay back the loan, the plan will report your default to the credit bureaus, harming your credit rating. And your spouse could end up having to wade through a loan that he or she may not have any idea about and pay the loan back, or worse, file for bankruptcy.

Compromising the Primary Purpose of Your 401(k) for Non-Retirement Purposes

A 401(k) account was created with the goal of providing you with a supply of funds for your retirement savings. Any time you take a loan from your account, you’re essentially sacrificing money that could have been destined for retirement.

This may be a non-issue if you’re taking a smaller loan, but the reality is that 401(k) loans can quickly escalate into more than you might expect.

The interest that a pension plan charges on loans is generally offset by earnings the pension plan makes on investments. However, these earnings are often minimal when compared to the interest on a 401(k) loan. Therefore, every loan from a 401(k) results in a significant loss of principal, and could even leave you digging deep into your retirement savings.

Likelihood of Poor Investment Choices

Another significant concern is that you’ll be making investments with relatively liquid assets.

The reality is that your 401(k) is designed as a retirement account. Most individuals only make use of their accounts at retirement. Once you begin making withdrawals, you’re going to incur substantial penalties for any early distribution.

This means that if you take a loan, you’re more than likely going to need to make the principal repayments on a regular basis. This leaves you in a position to need to make regular investments.