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401(k) loans come with caveats
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The credit crunch has dried up many loans, forcing debt-burdened Americans to seek other options. One easy-to-use alternative is a 401(k) loan. But be aware: It isn't necessarily a wise choice for most people.

Before you consider borrowing from your retirement savings, you need to assess all the risks. "Every decision is a trade-off," says Stuart Ritter, a certified financial planner at T. Rowe Price.

Federal law imposes no restrictions on how you can use the money from a 401(k) loan, though plan administrators can limit the money to certain purposes. The most common are medical expenses and student loans. Borrowers typically must pay back the loan within five years.

Having been reminded for years of the need to save for retirement, most employees avoid borrowing from their 401(k) account. In the past 10 years, the proportion of employees who have applied for 401(k) loans has remained fairly flat, at about 18%, according to a database of the Employee Benefit Research Institute and the Investment Company Institute.

But 401(k) loans could become a more popular option as lending standards have tightened and more Americans have found it harder to secure money from home-equity loans. There's already been a slight increase in 401(k) loan activity, Ritter says. But it's too soon to know how many more employees will dig into their 401(k) accounts.

Whatever the reason for the loan, pulling money out of your 401(k) — even when it's money you'll pay back — slows your ability to build a substantial nest egg for retirement.

"Before you take a loan from your 401(k) plan, do it with your eyes wide open, understanding the consequences and ramifications," says Clare Bergquist, director of 401(k) strategies at Charles Schwab. "It's your retirement nest egg."

The advantages:

•There is no credit check. That especially helps those who need money but have tarnished credit.

•The loan application is often much quicker than applications for bank loans. Some 401(k) plans require you to take out the money evenly from your investments; others let you decide how exactly to withdraw the money.

If you have the flexibility to take money from any fund you want, you might want to tap a fixed-rate mutual fund, Bergquist says, while leaving untouched the funds with higher rates of return.

•The loan interest rate is low. Many are just 1 or 2 percentage points above the prime rate. And the interest you pay goes to yourself.

•There won't be any surprises. That's a plus, especially in light of the many homeowners who have adjustable-rate mortgages that began at low interest rates that eventually reset to much higher rates, notes Jack VanDerhei of the Employee Benefit Research Institute and a professor at Temple University.

•Typically, you can borrow up to 50% of the amount you have invested in your 401(k) plan or $50,000, whichever is less.

•The most common 401(k) loans are considered short-term general-purpose loans with a typical payback period of five years or less. That forces you to repay fairly soon and to return to saving for retirement.

•About 75% of 401(k) administrators offer long-term loans that can be used only for a home, such as a for a mortgage down payment, says Hewitt Associates, which tracks midsize to large employers. They generally have a payback period of 15 years.

•Many companies simplify the loan repayment process by automatically deducting it from the borrower's paycheck.

The disadvantages:

•If you lose your job after you've taken out a 401(k) loan, you'll face a major financial crunch. Typically, in that case, you'll have 30 to 90 days to pay off the loan. If you can't pay in time, the loan will be considered a cash withdrawal. That means you will have to pay tax. And unless you're over age 59½, you'll also have to pay a 10% penalty to the IRS.

"When you're weighing your options, it's important to understand that this is a possibility," Ritter says.

And since you can't know for sure whether you will lose your job, it's not wise to rely on a 401(k) loan to take a vacation or improve your kitchen, even if your administrator allows you to use the money for those items, VanDerhei adds.

•You face, in effect, double taxation because you'll pay back the loan with after-tax money (unlike your contributions to a 401(k) plan, which are made with pretax money). Then you'll pay tax again once you retire and withdraw the loan payment money.

•Unlike with a mortgage or a home-equity loan, if you use a 401(k) loan to buy or improve your home, you won't get a tax deduction on the interest you pay.

•You may have to pay a one-time fee to the plan administrator for the cost of originating a loan; the fee averages around $50.

•If, after borrowing from your 401(k) account, you stop making contributions while you focus on repaying the loan, your account loses in two ways: Not only do your own contributions stop; so does the company match. (Hewitt Associates says 98% of employers offer some type of company match to 401(k) accounts.) As a result, your retirement income will grow more slowly.

•Just because you have a 401(k) plan doesn't necessarily mean that loans are allowed. Last year, 51% of all 401(k) plans allowed loans, according to EBRI/ICI data.

You'll have a much better chance for a loan if you work for a midsize or large company; 98% of those employers permit 401(k) loans, Hewitt says.

You should also know that 401(k) loans are not all the same. "Different employers have different structures, rules, paybacks and interest rates," says Pamela Hess, director of retirement research at Hewitt. Some 401(k) plans even allow an employee to take out several loans.

Experts warn against taking out one loan after another, just to provide more cash for daily expenses, even if you're allowed to do so.

"But if you have an illness or a family emergency, a 401(k) loan is the right thing to do," Ritter says.

The impact of a 401(k) loan
Say a worker has been making monthly contributions of $264 to his 401(k) account, which has been earning an annualized return of 8%. When, at age 40, he takes out the loan listed below and halts his monthly contributions, his after-tax monthly loan repayment would be $198, based on an interest rate of 7%.
Loan No loan
Initial 401(k) balance at age 40 $50,000 $50,000
Loan amount $10,000
Balance at the end of the 5-year payback period $74,143 $93,891
Balance at age 65 $520,799 $618,095
Source: T. Rowe Price
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