When choosing a 401(k) loan, we are proponents of this only if you're have no choice but to take money out of your 401(k). So let's take the same scenario from the 401(k) withdrawal article. In choosing this option, it is not the same as a consumer loan as seen with a mortgage. So let's take a $20,000 sample - the difference is that will pay back the loan to yourself with interest.
A key point of note is that not all plans provide for a loan provision so you will need to reach out to your human resources team or your company's plan administrator to validate they allow for loans.
Assuming that you have the green light to take a loan out, when you pay interest it is tracked via the prime rate; in addition, you need to consider that there's also loan origination fees and potentially other fees tied to this that get deducted from that.
Before taking a loan here are items to consider:
-It is possible that you may detract from the stock market-related growth that you'll have during the borrowing period.
-If you do leave your job, terminate your job or get fired, you are still responsible for paying the loan off so you can keep the same loan terms; however
-If you default at any time then you'll have a 100% taxable loan and/or a taxable distribution to your normal tax rate along with an early withdrawal 10% penalty imposed by the IRS. (This is the same penalties as a 401(k) withdrawal)
Understanding the Primte Rate
The prime rate is charged by banks to their most creditworthy customers and as of this articles' date, it's around 3.25%. In addition, the loan will also cost in the neighborhood of 1-2% on top of that. Hence, in this example, the interest rate would be 4.25 - 5.25% to borrow your money.
401(k) Loan Terms
Regardless of what the interest rate calculates to be, it is tacked on top of the loan meaning that you have to pay it back like a typical car loan. The rules say that you can pay up to five years on a 401(k) loan and when payments are made, the money goes back into your account.
What the Money is Intended For
The key point is to refrain from using the money as a savings account; it should be earmarked for your retirement planning to build that nest egg. When you take that money out it means you could be missing out on growth opportunities.
This means you will be taking this money from your 401(k) plan and it is not being invested in current securities; which most or all of it would be in your mutual funds or other investment securities.
When you take this money out it is positive in that you are paying interest back to yourself; however, the interest rate is typically lower than what you're going to make in the stock market per se. If this happens, you may miss out on compound interest opportunities.