The right to borrow from your account is an increasingly popular feature of 401(k) plans. Only 67% of all plans offered this option in 1991, according to Hewitt Associates. By 1999, it was a feature of 92% of all plans. But experts are unanimous in warning plan members to avoid taking such loans.

Brenda Newmann, managing editor of mPower, an online investment advisory service for 401(k) members, said: “People say, ‘Gosh, it’s my money. Why can ’t I get at it easily?’ The answer is that it’s for your own good.” Your company would prefer that your account has a chance to grow. “People should remember that their 401(k) account is for retirement,” Newmann said. “If you don’t treat it that way, you’re setting yourself up for a different kind of retirement than the one you want.”

She added: “When you borrow from your account, you’re taking out money that could be earning compound interest. Your end balance will be smaller.” David Wray, president of the Profit Sharing/401(k) Council of America, cautions that you should borrow from your account only if the ends justify the means.

“Borrowing from your account is very expensive,” he said. “You should do it, if at all, only for serious reasons. If it’s to pay for a vacation, forget about it. If it’s for serious reasons like a medical emergency or higher education costs you can think about it.”

Besides, borrowing from your account isn’t your only option. You can also charge expenses on a credit card or take a home-equity or personal loan. Each type of loan has different costs. So does borrowing from your 401(k) account.

But you don’t have to be a Ph.D. in math to figure out your best deal. “Here ’s how to decide,” said Wray. “Look at this from two angles. First, look at yourself as a borrower.” That means asking yourself where you can get the best interest rate and the least paperwork.

“You have to repay a loan from your 401(k) account with interest,” he said. “The cost is usually prime rate plus 1 percentage point. It’s also hard to beat for ease of repayment. You’d do it through payroll deduction. It’s automatic.”

But consider other factors, too. “Now put on your other hat,” Wray said. “Look at this as an investor in your 401(k) plan. The interest you pay your account is like a fixed-income investment. If prime plus one equals 10%, you’re collecting 10%, rather than whatever rate of return you could get on other investments.”

Last year, for instance, Vanguard 500 Index fund would have gained more than 21% for you, more than twice the return of loan repayments at 10% interest. What’s To Lose The roughly 11% difference is your lost-opportunity cost. In addition, as an investor in your account you also must weigh the risk that the amount of your loan won’t be repaid, says Wray. Why would you stiff yourself? The danger lurks in an unexpected layoff or job change.

“On your last day at work, if you can’t write a check to cover the entire outstanding balance of the loan, it’s likely the loan will be treated like a distribution,” said Wray. “It’ll be taxed at ordinary income rates. And if you don’t qualify for an exemption, you’ll be hit with a 10% early withdrawal penalty. Plus, you might get hit with state taxes.” You could end up owing half the balance in taxes, Wray says. In contrast, a home-equity loan has no sudden repayment booby trap built in.

It also may be much cheaper than you expect. The amount you can borrow is based on your equity in your home. You can calculate that by subtracting the outstanding balance of your existing mortgage from your home’s appraised value.

Banks typically prefer to lend about 80% of the equity amount, says Margaret Lawlor, senior vice president of Fleet bank’s consumer lending division. “Lending 100% of the equity is risky,” she said. “Your home value could decline, for example. If a bank is willing to lend you 100% of the equity, it will probably charge a higher interest rate.”

An 80% equity loan would cost you 9% in interest a year from Fleet these days, she adds. A 100% loan would cost 10.5% to 11%.

Home Sweet Home
“But your (home-equity loan) interest is deductible,” Lawlor added. “So that 9% loan would cost you only about 7% to 7.5%.” That’s cheaper than a 401(k) loan. Plus, more money stays in your account, growing tax-deferred.

Also, interest paid on a 401(k) loan is not tax-deductible. Neither is interest on a personal, car or credit card loan. A home-equity loan also costs less than a personal loan. A $10,000 personal loan from Fleet would involve an interest rate of 13.25% to 14%. A personal loan isn’t backed by collateral. Since it is unsecured, a bank won’t want to lend you much.

Many banks don’t want to make a personal loan for more than 50% of someone’s take-home pay after subtracting such ongoing expenses as mortgage payments, says Lawlor.

“A home-equity loan is a better way to borrow 99 out of 100 times,” Lawlor said. “And it’s typically better than borrowing from a 401(k) plan, especially when you factor in the tax deduction on interest and the benefit of keeping money invested in a 401(k) plan.”