3 Reasons 401k Loans Can Be a Smart Move

Historically, financial advisers have warned clients to stay away from 401k loans. They have been considered highly risky due to the way they compromise long-term retirement savings in the name of short-term cash. While the money is out on loan, not only is interest assessed against it, but it also cannot earn any money through investment. Further, if the individual loses his or her job, the loan must be paid off within 90 days. Despite all of these drawbacks, financial advisers have become more open to the prospects of a successful 401k loan strategy. The main reason is the comparatively lower cost over alternative options.

#1 Lower Interest Rates

Compared to the market as a whole, 401k loans typically have relatively low interest rates. The rates run from one to two points above the prime level. For a high-risk borrower, a number of loan options will be much higher interest than this relatively low rate. For example, even an auto loan can be three to four percentage points over prime for a moderately risky borrower. Credit cards tend to have among the highest rates in the loan market. If a specific borrower is comparing the interest rate on several kinds of loans, he or she will almost always find the 401k loan has a lower cost due to interest.

#2 Lower Processing Fees

Another factor that brings down the cost of 401k loans compared to alternatives is processing fees. The origination fee for a loan from your 401k account tends to be very low. Not all companies allow employees to take loans from their 401k. Those that do, however, have fairly direct processes for taking loans. Instead of going through a third-party organization, an employee follows simple steps through the company's 401k provider. Since the borrower sees no benefits from processing fees, eliminating the fees in any way possible makes sense. It reduces the up-front cost of the loan, allowing an individual borrower to potentially take a smaller loan.

#3 Lower Opportunity Cost

When it comes to determining which option will be truly more expensive, opportunity cost is the key factor. Despite the fact interest rates and processing fees are typically lower on a 401k loan, it still may be the more expensive option on the whole. A borrower must decide whether the interest rates on an alternative option will be higher than or lower than the interest earned on the money in the 401k fund during the same period of time. If the money in the account will out-earn the expense of the other loans, then the wisest option may be to leave the cash in the account and simply use an alternative option. However, depending on the economic circumstances, the money in the account may fail to out-earn interest rates. In this case, it would be smarter to take the money out for a short period of time. This is particularly true in a recession. During a recession, the earnings will be low and interest rates on other loans will tend to be higher. Therefore, a 401k loan during a slow economy can be the lower opportunity cost option.