What are 401(k) loans and what are they used for?

Workers who have a 401(k) retirement plan in the United States have the possibility of applying for financing under preferential conditions, thanks to 401(k) loans.

Here we tell you what they consist of, their characteristics and their advantages when applying for them.

What are 401(k) loans?

Essentially, it is a financing that you make to yourself using the retirement account you have with your employer as collateral to obtain better conditions than with a traditional personal loan.

401(k) loans work the same way as any other loan, with an interest rate, a term, and certain conditions and fees. Therefore, the repayment schedule depends on the interest rate assigned and the amount you request.

401(K) loans

According to the Internal Revenue Service (IRS) regulations, you have 5 years to pay back the money if you are not going to use it to pay for your first home. Another important aspect about 401(k) loans is the fact that you don't need a good credit score, which is always good news.

Pros and cons of taking out a 401(k) loan

Before you decide on a 401(k) loan, you should know that there are several disadvantages associated with this financing option. Although many Americans believe that the advantages outweigh the risk, it doesn't hurt to keep this in mind. Among the cons are:

  • Limited amount. You may not have access to as much cash as you would like. This is because you can only apply for 50% of what you have saved or a maximum of $50,000 (whichever is less).
  • There is a possibility that you may not be funded. This depends on the retirement plan you have agreed upon with your employer.
  • Old 401(k) accounts do not qualify. When you want to opt for this alternative with a company you no longer work with, it will not be possible. Unless you have rolled that money into your current plan, there is no way they will give you credit.
  • If you don't have a job, you have to pay it off first. When you change jobs, you will have to pay the outstanding balance before the established 5 years. Before it was only 60 days, but under the new tax law you have until the next tax return to repay. For example, if you left to another company in March, the deadline would be April 15 of the following year.

You may be interested in: What are IRAs for retirement?

With that understood, 401(k) loans also have several advantages that offset the above negative points:

  • You avoid the early withdrawal penalty. You don't have to pay the taxes associated with this action and the interest paid goes back into your account on an after-tax basis.
  • No credit inquiry is required. With this option you don't need to have good creditworthiness and if for some reason you default, it won't be on your credit file. So you don't have to worry about your default appearing on the major bureaus.

3 ideal situations in which to apply for a 401(k) loan

According to experts, you should apply for a 401(k) loan in one of these instances:

➤ When you have high-interest debt

It's a good idea because the prime rate is at 5% and those who use this financing pay 1% or 2% above that benchmark. This is much more reasonable than paying a debt with a rate of 15% or more, as credit cards usually apply. However, before using this option you should exhaust the other alternatives available to you.

In any case, this financing is more convenient than making an emergency withdrawal, known as hardship distribution, where it becomes taxable and has a 10% penalty.

If it is a specific need, such as medical expenses or a permanent disability, these plans offer exemptions and do not charge the 10% withdrawal fee. There are several instances for the exemption and we recommend you inquire if you qualify before applying.

➤ In the event of a financial emergency

This alternative may be viable during extreme lack of liquidity or if you are having financial problems. An example would be when one partner loses their job and they are having a hard time making ends meet.

The employed person could turn to the 401(k) loan to get through the situation while the other gets a job.

➤ When you're making a down payment on a home

Since buying a home requires a good sum of money, at least 10% of Americans have used their retirement accounts to take out their first mortgage. This usually makes financial sense if you intend to make a down payment.

The key here is that the amount you ask for allows you to continue saving for your retirement. The recommendation is to ask for no more than $10,000 and to take into account current real estate market conditions.

English: ¿Qué son los préstamos 401(k)?