Personal Finance

A 401(k) Loan Might Make Sense, but it Should Only Be Your Last Resort

If the situation is right, a 401(k) loan could work in your favor.

Source: Flickr user Mark Moz.

When a 401(k) loan makes sense

For instance, a 401(k) loan, which is most often structured as a five-year repayment plan, can sometimes have substantially more attractive lending rates than what you'll find at a bank or credit union, or even from family and friends. If you have an average-to-poor credit score, your access to a loan, or a loan at a non-"arm-and-leg" interest rate, could be limited. A 401(k) loan typically is a few percentage points above the prime rate (currently 3.25%), and -- best of all -- the interest paid on the loan winds up going back in your pocket.

It's also worth noting that taking out a loan against your 401(k) won't hurt (or help) your credit score. If you fail to make your payments, you'll simply be required to pay taxes and possible early withdrawal penalties on the money you've taken out. Again, it's a potentially smart move for an individual with a low credit score who otherwise may not be able to get a loan.

If you have an eligible reason it could be worth borrowing from your 401(k), too. This doesn't mean you want to buy the latest car to impress your friends. Instead, it means putting a down payment on a new home -- since you can't borrow from an IRA, using a loan from a 401(k) is a cash-ready option -- or potentially paying off an unexpected medical bill.

And, of course, if you've exhausted every resource available -- a home equity line of credit, personal loan, or even a loan from a friend or family member -- then a 401(k) loan might be the appropriate path to take.

...but a 401(k) loan comes with a potentially hefty price

However, investors need to understand that a 401(k) loan comes with a potentially hefty price tag attached.

Source: Federal Reserve Bank of New York.

First and foremost, borrowing money from your account denies that money the chance to compound over time. A low lending rate might be preferable when paying back a 401(k) loan to yourself, but money invested in the stock market historically earns about 8% per year. Chances are the longer the money is out of your account as a loan, the more compounding power you'll lose.

It's also worth noting that taking a loan out against your 401(k) is going to expose you to the dreaded "double-taxation." Money that's used to repay a 401(k) is after-tax dollars, and the money pulled out at retirement is also after-tax dollars. In the end, even after repaying your loan you'll likely wind up with less in retirement than if you had never taken out a 401(k) loan in the first place.

A 401(k) loan may not adversely affect your credit score, but it does come with risks that you may not be aware of. For example, failure to pay back the loan within the specified timeframe (usually five years) will trigger an early withdrawal penalty of 10% if you're under the age of 59 1/2 and subject the withdrawal to ordinary income taxes, and could exclude you from contributing to your employer-sponsored 401(k) in the future. It's actually not uncommon to be denied the ability to contribute to a 401(k) as long as you have an outstanding loan against your plan, further hampering your ability to save and allow time and compounding to do their work.

Source: Federal Reserve Bank of New York.

Additionally, if you lose or quit your job, your 401(k) loan often needs to be paid back in an accelerated fashion, within 60 or 90 days. If you don't, you'll be exposed to income taxes and possible early withdrawal penalties. If you don't have rock-solid job security, then taking out a 401(k) loan is typically an unwise move.

Lastly, you'll need to understand that your take-home pay will be reduced because of your regular monthly repayment. Pulling out quick and easy cash to cover a debt might seem like the right move this very moment, but when your other bills keep rolling in months from now your earning power will be reduced by your 401(k) repayment.

Ultimately, consumers need to carefully weigh the immediate benefits of a 401(k) loan against its possible long-term implications. I'd be willing to bet that borrowing against your 401(k) is most often a poor idea, but as I said above, under certain circumstances taking a 401(k) loan could be a reasonable option.

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The article A 401(k) Loan Might Make Sense, but it Should Only Be Your Last Resort originally appeared on Fool.com.

Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, track every pick he makes under the screen nameTrackUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insights makes us better investors. The Motley Fool has adisclosure policy .

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