Why take a loan from your retirement plan?

You should take a loan from your retirement plan only if you have exhausted your other financing options, or if the loan will help to improve your finances. For instance, if you had credit card balances of $20,000 with an interest rate of 15% and you could afford to pay $400 per month, it might make sense to take a loan from your retirement plan in order to pay off your credit card balances. Let's compare the two scenarios:

Retirement plan loan amount

$20,000

Credit card balance

$20,000

Interest rate

4.5%

Interest rate

15%

Payment frequency

Biweekly

Payment frequency

Monthly

Payment amount

$171.94

Payment amount

$400

Repayment period

Five years

Repayment period (if repayment is $400/month)

Six years, seven months

Total interest

$2,351.41

Total interest

$11,582

While it is true that the $2,351.41 you pay in interest on your loan amount will be taxed twice, the obvious benefit is that the interest will be repaid to you, instead of to a credit card company, and the amount you pay in interest will be significantly lower.

If you do take a loan from your retirement account to pay off your credit card balance, make sure you take steps to avoid going into credit card debt again.

Another good reason to take a loan from your retirement account is to purchase a home. Depending on the market and your finances, buying a home can provide a significant return on investment. Furthermore, you could also use your home to finance your retirement, whether by selling it or by taking a reverse mortgage.

Check your plan provisions

Not all qualified plans allow loans, and some allow them only for special purposes, such as purchasing, building or rebuilding a primary residence, or paying for higher education or medical expenses. Others allow loans for any reason. Your plan administrator will be able to explain the loan provisions under your retirement account.

Replenish your account after you take a loan

If you must take a loan from your retirement account, try to continue making contributions and to increase the amounts you contribute. This may be a challenge, as you will also be required to make loan repayments, and those repayments will not be considered contributions to your retirement account. However, it will help you restore your nest egg more quickly.

Most plans will allow you to accelerate your loan repayments, which will help to restore your plan balance more quickly. Be sure to factor your loan repayment in your budget.

The bottom line

You should not take a loan from your retirement account unless it is an absolute necessity or it makes good financial sense. You will need to assess your finances and compare the retirement-plan loan with other options. It's a good idea to discuss the matter with your financial planner, so that he or she can help you decide which option is best for you.

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