Recession Solution: Rethinking 401k Loans

The interest rate paid on a 401(k) loan typically falls within 1 or 2 percentage points of the prime rate, significantly lower than what's usually paid on a credit card, auto loan or other consumer debt. However, borrowers can often do better with a mortgage or home equity loan thanks to lower rates and the mortgage interest deduction.

Li and Smith offer a list of four questions potential 401(k) borrowers might ask themselves before taking out a 401(k) loan through an employer:

1. If you did not borrow from your 401(k), would you borrow that money from some other source (e.g., credit card, auto loan, bank loan, home equity, etc.)?

2. Would the after-tax interest rate on the alternative (non-401(k)) loan exceed the rate of return you can reasonably expect on your 401(k) account over the loan period?

3. Would you be able to make your 401(k) loan payments without reducing your regular 401(k) contributions?

4. Are you comfortable with the requirement to repay any outstanding loan balance within 90 days of separating from your employer, or pay income tax and a 10 percent penalty on the outstanding loan?

A "yes" answer to each of the four questions could mean a 401(k) loan is a better option, according to Li and Smith. A single "no" suggests other option should be considered.

I'm not ready to abandon my general advice against 401(k) loans, but the Fed research paper is making me think about circumstances under which one might not be such a bad idea.

I certainly wouldn't use a 401(k) loan to finance a fancy vacation, but if you face a pressing financial need and don't have access to other low-cost borrowing, then it might be worth considering.

But tread carefully.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com.

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