Borrowing money from your 401K is usually a very bad idea. This is especially true if you’re planning on using the money for something silly like buying a boat or going on a vacation. As my wife and I learned a few years back, it doesn’t take long for your debt to get out of control.
However, there are cases when it might actually be a good idea to borrow money from your 401K (buying real estate properties to rent out is not one of them).
If you remember back to last week’s personal finance case study, one of the recommendations I had for the young couple struggling with debt was to sell one of their expensive vehicles and get a less expensive car.
If you owe less on your vehicle than it is worth, you can easily sell the car, pay off the remaining balance of the loan and buy a less expensive vehicle. Even if you need to borrow a few thousand dollars to buy a less expensive car, it’s better than having a $20,000 loan hanging over your head for your current car.
But what if you owe more on your car than it is worth (negative equity)? If you owe more on your car than you can make selling it, the best option is to speak to the bank who owns the loan and ask them if they would allow you to borrow the difference between what you owe on the car and what it is worth (so you can sell the car). Unless you have a really strong credit rating (720+ FICO Scores) or have other assets to use as collateral, this is probably not an option.
Using your 401K balance as a tool: If you have money in your current employer’s 401K program, you may have the option of borrowing money from the account to use as you wish. When you borrow money from your 401K account, you pay the interest back to yourself (instead of a bank) which helps to sweeten the deal.
Lets say you owed $5,000 more on your current car than it is currently worth and your efforts to borrow the difference from your bank or local credit union have failed. You could borrow $8000 from your 401k, sell your current car (paying the difference from your 401K loan proceeds) and buy an inexpensive yet reliable car for $3,000.
Instead of owing the bank $20,000, now you owe yourself $8,000 and the interest you’re paying goes to you as well!
The drawback of borrowing money from your 401K is that you have 60 days to pay the money back if you lose your job or you’ll be forced to pay income taxes and a 10% penalty on the outstanding balance of the 401K loan.
Another factor you need to consider is that funds borrowed from your 401k may not have the same protections from lawsuits and bankruptcy as funds that remain in your 401K.
Too Much Debt? Download our free Trees Full of Money Debt Snowball Calculator and see how quickly you can pay off your debt.