When life throws you a financial curveball, it can be very tempting to borrow from your 401k. But if you do that, you'll miss out on the market gains while the loan is outstanding, and if you default, it's treated as a permanent distribution that comes with taxes and early withdrawal penalties.
Read on to learn about other options to consider before you decide to take out a loan from your 401k.
In the event of severe financial distress, it might be time to tap into your emergency fund. Your emergency savings account should be one of the first ways to compensate for the financial shortfall — that's what it's there for, after all. Your emergency fund should have between three and six months' worth of expenses so that you can weather the financial storm. Then, when you're in a better financial position, you can rebuild the fund.
Home Equity Loan
If you own your own home, you might be better off taking out a home equity loan to pay for a large, fixed expense. With a home equity loan, you borrow a specific amount up front, often at a fixed interest rate. The loan is secured by your home, however, so if you default on the home equity loan, the bank can foreclose on your home.
Home Equity Line of Credit
When your financial distress is ongoing or you don't know exactly how much it's going to cost, consider a home equity line of credit instead of a home equity loan. A HELOC sets a maximum amount that you can borrow on an as-needed basis, and you can make minimum payments during the draw period. HELOCs usually carry a variable interest rate, however, and, like a home equity loan, the loan is secured by your home.
0% APR Credit Cards
Taking advantage of a credit card offer promising a 0 percent introductory interest rate could help you manage your short-term expenses without having to tap your retirement nest egg or pay interest. Read the fine print, so you'll know how long the introductory interest rate stays in effect and any conditions for keeping the interest rate at zero for as long as possible.
Borrowing From Friends and Family
Friends or family who have the means to lend you money might be an option. You could ask them for a low-interest loan to help you get back on track financially if you feel comfortable doing so. Document the terms and amount of the loan so that everyone involved has a written record. With this option, you won't have to go through a bank's credit check or application review, but you could risk your relationship if you can't repay the loan as agreed.
When you don't have a home to borrow against, or you don't feel comfortable asking family, a personal loan could be an option for you. A personal loan is an unsecured loan with a fixed interest rate that can allow you to pay for expenses over a longer period. The interest rate is based on your credit score, and if your credit score isn't great, you could end up paying a high interest rate.
Peer-to-peer loans are unsecured loans that are funded by individuals instead of banks. The application process is similar to a personal loan, except you're cutting out the bank as the middleman and might qualify for a lower interest rate. The interest rate varies depending on various factors including your credit score, how much you're borrowing and how much you're already in debt.
Click to discover the best peer-to-peer lenders.
After paying down your mortgage for years, you've probably built up some equity in your home, especially if you live in an area with skyrocketing home prices. To get a lower rate on your mortgage, a cash-out refinance would allow you to refinance your home for more than you currently owe and cash out the excess. For example, if you owe $100,000 on your home valued at $200,000, you could refinance for $120,000 and receive the extra $20,000 cash to help with other expenses. Taking advantage of this option means that you won't be able to pay off your mortgage as quickly, but it might be worth it depending on the severity of your circumstance.
Certificates of Deposit
CDs that haven't matured yet can be cashed in early to pay your bills. When you terminate your CD early, you usually pay an early withdrawal penalty equal to a few months' worth of interest, depending on the length of the CD. The penalty could be small, however, relative to the investment gains you would miss in your 401k or the 10 percent early withdrawal penalty and taxes that you would owe if you defaulted on your 401k loan.
It's a very drastic step, but in certain circumstances, filing for bankruptcy could be a better financial option for you than tapping your retirement plan. When you take a loan first, you'll still have to repay the loan or it will be treated as a distribution. Qualified retirement plans are generally exempt from creditors, so if you're in a hopeless situation, you could protect your 401k balance by declaring bankruptcy. For best results, consult a credit counselor or lawyer before taking any drastic steps.