Pros and cons of borrowing from your 401k retirement fund to pay off debt, as compared to other types of loans.
First, consider why you are taking out the money in the first place. Are you draining your account to pay for an item that will immediately depreciate in value, such as a new car or boat? Or do you really need the money to pay a major expense, like college tuition? If the money is not for an immediate, unavoidable expense, take a few days to think about the need for the money. If the expense is not truly necessary, don't even think about taking out that loan.
Second, look into alternate sources of money to cover the expense. Home equity loans are another option that will reduce the amount of equity you own in your home, but will have lower repayment amounts since they are paid off over a longer time frame. If you are able to repay the loan quickly, think about taking out a personal loan from your bank or credit union that does not penalize you for repaying the loan early. If you have an emergency fund set up or stocks and/or mutual funds that you own, consider liquidating these assets first to decrease or eliminate the need to tap your 401(k) account. Depending on your 401(k) account, you may pay more or fewer fees to borrow from your 401(k) than taking out a home equity loan or personal loan. Another option is to open a line of credit based on your home equity, rather than taking out a loan. This is ideal if you know you will need access to funds for a large expense (such as college tuition and expense) but do not need the money all at once, and/or may not need the full amount of the loan, depending on how circumstances play out.
Third, you need to consider whether a loan from your retirement account makes sense in terms of your job stability. While loans from 401(k) account are usually repaid over a period of 1-5 years, the loans must often be repaid immediately should you leave or otherwise lose your job. If you are taking out a loan for several thousand dollars, can you afford to repay that amount on short notice? If not, then consider how stable your job is in terms of the company's stability and your own position within the company.
Finally, you need to consider the real cost of borrowing from your retirement fund: opportunity cost. When you withdraw money from your 401(k) account, that money is no longer earning tax-free interest for your retirement. If you take 5 years to repay that loan, you will lose the 5 years worth of interest that money would have earned. For example, if you take a loan for $10,000 from your retirement account, and the account earns 10% a year for that 5-year period, then you will miss out on $5,657 of tax-free earnings that otherwise would have added to your account. If you had left this extra $5,657 in your account for another 25 years, it alone would generate $68,206 at 10% gain per year. So, take a loan from your 401(k) if you absolutely need to, but if the loan is for something that is not truly necessary, think about the number of toys and vacations you will be able to take in retirement with that extra $68,000 you have saved!
