Rates are up. Is it time to borrow from your 401(k)?
Over the last couple of decades, we watched interest rates go lower and lower. Mortgage rates declined for so long that it seemed to make sense to refinance your mortgage every few years. Car loans were cheap, too, with 0% financing deals hard to resist. Credit cards offered balance transfers to a new card at 0% for 6 months or more.
No more.
While there are still a few 0% interest rate offers out there, most are gone. And, the rate on a new mortgage has risen from 3.1% a year ago to 6.5% as of the end of last week.1 This means the cost of acquiring some big things—especially cars and houses—has gone up a lot.
One place working folks can borrow from is their own 401(k) plan. Many plans offer an option to borrow against the balance and then pay it back over time.
As someone who advises companies and plan participants on 401(k) plans, employees often ask me if it is a good idea to borrow from their plan. I usually say that people should think about borrowing from their 401(k) as a last resort. In other words, if one desperately needs cash for an emergency (such as a mandatory medical procedure that is not covered by insurance) and there are no other options, a 401(k) loan can be a lifesaver.
However, things have changed a lot in 2022.
While I still think leaving your retirement plan alone and, saving and paying cash is almost always the best option, the current environment has changed longstanding assumptions.
First we need to understand how a 401(k) loan works. Basically a 401(k) loan is a loan from yourself. Effectively you become your own bank. This means that when you borrow, you are paying it back, with interest, to your own 401(k) account.
The borrowing rate is typically the Prime Lending Rate (currently 6.25%) plus 1% which is set by each plan. When you borrow, you normally must pay back the balance in five years. However, if you are using the proceeds to purchase a primary residence, you can extend the payback period to up to 30 years.
Plans that have loan features allow you to borrow up to the lessor of 50% or $50,000. In other words, if you have a balance of $60,000, you can borrow up to $30,000 (50% of 30,000). Or, if you have a balance of $120,000, you can borrow up to $50,000—the maximum dollar loan.
Why a 401(k) loan might make sense right now
With stock and bond returns generally negative so far this year and the Federal Reserve attempting to slow down the US economy by raising rates, it has been hard to get excited about investing. However, if you could earn 7.25% on your money in a relatively low risk investment2 for the next five years, some people might jump at that opportunity.
To loan or not to loan?
Another way to think about the decision is this way: Do you think that a diversified investment in your 401(k) will outperform a 7.25% return? Remember, YOU are the lender and you would receive a 7.25% return by loaning the money to yourself. If you think that the loan will provide a better return, chose that. If you think that your investments in your 401(k) will do better, chose that option.
Additional considerations
Keep in mind that when you take out a 401(k) you will be committing to a loan repayment schedule just like a regular loan. Your repayments will be deducted from each paycheck automatically (which is a good thing for most people). Yet, you need to have enough money left over after the loan payment to pay your bills. Also, if your company is not doing well or likely to start laying people off, this may not be a good strategy (see footnote on risks below). Lastly, where you invest the loan proceeds also makes a difference, too. For some, remodeling their home is a good investment. For others, paying off higher interest debt is a good choice.
So, if you think 7.25% is a pretty good return, give me a call and we can discuss if taking a loan makes sense. You can also schedule a quick call with me by clicking HERE.
Lyman H. Jackson
Lyman@PlanWithFPS.com
617-653-3303
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· Big IRA’s: When maxing out a 401(k) / 403(b) doesn’t always make sense https://planwithfps.com/blog/big-iras-when-maxing-out-a-401k403b-doesnt-always-make-sense
1 Source: JP Morgan Asset Management, Weekly Market Recap, 30-fixed rate mortgages as of 9/30/2022.
2 Taking out a loan against your 401(k) involves risk including the risk that you may lose your job and be unable to pay back the loan. If that happens, and you cannot pay back the outstanding balance, the loan is deemed a distribution by the IRS. This means that in most cases you would have to pay income tax on the outstanding balance and, if you are under age 59½, you would also have to pay the 10% early distribution penalty. Before you take out a 401(k) loan, carefully consider whether you can afford this risk and how likely it is that you may lose your job.
Financial Planning Solutions, LLC (FPS) is a Registered Investment Advisor. FPS provides this blog for informational and educational purposes only. Nothing in this blog should be considered investment, tax, or legal advice. FPS only renders personalized advice to each client after entering into an advisory relationship. Information herein includes opinions and forward-looking statements that may not come to pass. Information is derived from sources believed to be reliable. Information is at a point in time and subject to change without notice. Such information may not be independently verified by FPS. Please see important disclosures link at the bottom of this page.