What to Know Before Borrowing Against Your 401k

Borrowing against your 401k should only be considered as a last resort loan option. Other forms of private loans will be more financially beneficial to you. However, if you are unable to get funding from another source and are in immediate need, some employers will allow you to borrow from your 401k fund. These loans are very different than other loans. You are basically making a withdrawal from your account and then paying the funds back later.

Advantages

The main advantage of borrowing from a 401k is you are essentially borrowing from yourself. This means you do not have to undergo the same screening process you receive when you are borrowing from another lender. Most people who consider borrowing from a 401k have bad credit, leading them to this option. You will be able to borrow up to 50% of the monies you have fully-vested. This can amount to a very large loan without any credit check, a down payment or collateral.

Loan Limits

You can only borrow up to 50% of vested funds. This can be tricky for some people who do not understand the contribution process. When you contribute funds automatically in each paycheck, the funds hit the account very quickly. It is against the law for your employer to wait to deposit the contributions you have individually made. All contributions must be deposited within the 15th business day in the month following your contribution.

However, many people are confused by the fact the employer does not have to immediately match the contribution. Many employers have a quarterly deposit schedule for their matches. You may only borrow against the sum that is fully vested at the time your contract is complete.

Loan Terms

First, it is necessary to understand most loans must be repaid within 5 years of the initial loan. If you fail to meet this requirement, you may be penalized for an unscheduled withdrawal from your 401k. This is a 10% penalty on the funds if they have been taken out prior to the time you are 59 1/2 years of age. These loans also cost more than just their interest rates. While the funds are on loan to you, they are not earning interest in the account. Further, you cannot make the withdraw for any type of purchase. The loans can only be taken to pay for a home purchase or student loans. You cannot simply pay off other debts with a 401k loan.

Tax Penalties

You will have to pay taxes on your loan amount when you receive it. Since your funds are not taxed when they are contributed, they have to be taxed on the back end. The tax rate is typically around 20% for most Americans. This means borrowing from your 401k can be exceedingly expensive in real dollars. It is a better option to consider a high risk personal loan rather than using this option. You may be tempted to use this option now, but you will pay for it in the future when you go to retire.



Are you allowed to borrow from your 401k if you are not fully vested?



You can borrow fully vested funds only when you are borrowing against your 401k. If you have made deposits through your regularly occurring paycheck, the funds are immediately fully vested, and there is nothing to be concerned about. However, your employer's match may not be funded immediately. In this case, you can borrow those funds only once they do hit your account. At any given point, you may contact your 401k administrator to learn the amount you have fully vested in your account. You can then borrow up to 50 percent of this sum if your employer permits 401k loans.



If you borrow against your 401k, does that show on a credit report?



If you are borrowing against your 401k, the loan is not reported to the credit bureaus. You are technically borrowing money from yourself, and no lending agency is extending the financing. On the one hand, this sounds like a great option, but on the other, there are many credit drawbacks to the loans as well. Since they are never reported, they do not help build your credit score. For example, you can borrow from your 401k to pay for college tuition for yourself and a dependent. However, if you qualify for a federal student loan, you will receive low interest rates, and you will build your credit in the process. 

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