I have always been opposed to 401k loans. There are many downsides. The money comes out of the market, potentially losing on growth and compounded returns. The borrower is unlikely to continue saving in the 401k while making loan repayments. And there’s a risk that the loan becomes taxable if the borrower leaves their job before the loan is repaid. Many loans are due immediately (or within 90 days) if the employee separates from the employer. This can be for any reason, including a layoff.
However, I have found a very good exception to my opposition to 401k loans; the temporary need for liquidity. In my case, I am under contract to buy a new house. I do not plan to sell my current house until I move out and make repairs. This means I will temporarily be carrying two properties. The equity in my current home is a big part of the down payment I plan to use to buy the new house. I found that a 401k loan is a quick and efficient solution for bridging the gap between the purchase of the new house and the sale of my current house.
With trepidation, I logged into my 401k website and requested a $50,000 loan. The process was quick, and I assumed it would take a few days to approve. Unbeknownst to me, the plan provider cut me a check and mailed it to me the next day. Other than the use of snail mail, it couldn’t have been easier. My bank also put an annoying 7-day hold on depositing the check, but luckily there was plenty of time before the closing. My suggestion, this should be available via wire or ACH transfer to my checking account. I lost out on 14 days of interest.
The interest rate on my loan is a whopping 7%. I chose a 60-month repayment schedule, the longest option available. My first loan payment of ~$990 was made before I received the check in the mail. Here’s the kicker, the interest I pay back to myself does not count against the maximum contribution I can make to the 401k plan this year. I can potentially max out the 401k with $22,500 in savings, plus the interest payments on the loan, plus my company match, plus my plan allows for after-tax contributions. I could, if I wanted to, put $61,000 in my 401k plan plus the interest on the loan this year. I don’t think I’ll max out the after-tax contributions, but it is available to me.
My original plan was to pay off the loan as soon as I sell my house. But I may run the numbers and see if making interest payments over time is a better deal. I am still missing out on market growth while the loan is out. I’ve essentially taken my asset allocation down from 100% stocks to a lower allocation to stocks with a bond yielding 7%. That doesn’t seem so bad. This would have been an extremely lucky allocation in 2022.
In short, a 401k loan can be a great leverage strategy for those who have the income to pay the loan while still making contributions to the plan. I wouldn’t recommend doing it simply for the sake of taking the loan. But if you have a need for short-term liquidity, this option makes a lot of sense. Plus, the banks do not consider a loan to yourself as indebtedness when calculating how much credit you can obtain. I never imagined I would be in favor of taking a 401k loan, but in this limited (and privileged) situation, I must change my tune.