Benefit: Cost Advantage
There’s no cost, other than a modest loan origination or administration fee, to tap your 401k money for short-term liquidity needs.
Let’s go over how it works: You specify the investment account from which you want to borrow the money, and those investments are liquidated for the loan period. So, you renounce any positive earnings that those investments would have made for a short time.
And if the market is down, you’re selling these investments at a smaller cost than you would at other times. The benefit is that you also avoid further investment losses on that capital.
The cost advantage of a 401k loan is the equivalent of the interest rate set on a similar consumer loan without any lost investment earnings on the principal you borrowed. The simple formula goes like this:
Cost Advantage = Cost of Consumer Loan Interest – Lost Investment Earnings
Let’s say you take out a bank loan or a cash advance from a credit card at an 8% interest rate. Your 401k portfolio is generating a 5% return. Your cost advantage for borrowing from your plan would be 3% (8 – 5 = 3).
A plan loan can sound appealing whenever you can estimate that the cost advantage is positive. Remember that this calculation ignores any tax impact, which increases the plan loan’s advantage because consumer loan interest is compensated with after-tax dollars.
