Thinking of a 401(k) Loan? Here's Why You May Want to Reconsider.

If you're short on cash and need money in a pinch, borrowing from your 401(k) might seem like an easy solution. After all, you're borrowing from yourself, which means the interest you pay on your loan goes back into your own retirement account. That can make a 401(k) loan sound much more appealing than relying on a credit card or personal loan.

When you apply for a regular loan, your lender typically performs a credit check. If your credit score isn't in the best shape, it could stop you from being able to borrow the money you need.

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The nice thing about 401(k) loans is that there's no credit check required. If your plan allows for these loans and you meet the requirements, you can borrow up to $50,000 or 50% of your vested 401(k) balance, whichever is less, provided your balance is above $10,000.

But before you take out a 401(k) loan, it's important to understand the risks. Even though falling behind on a general loan or credit card payments could have consequences, the fallout from failing to repay a 401(k) loan could be more severe than you'd think.

The problem with 401(k) loans

There are a few issues with 401(k) loans you should know about before going this borrowing route. First, once you take out your loan and your money leaves your 401(k) plan, it can't continue growing until you pay it back. That means you could lose out on years of growth.

An even bigger problem is what happens if you're unable to repay your 401(k) loan.

First, you may just plain fall behind on 401(k) loan payments because money is tight (hence your need to borrow in the first place). However, if you leave your job, whether because you get a new one or are laid off, you may, from that point, have to repay your 401(k) loan in a very short amount of time.

If you fail to repay your 401(k) loan for whatever reason, it will be considered a withdrawal from your account. At that point, it becomes a sum you have to pay taxes on.

Worse yet, if you're under 59 1/2 years old, you could face a 10% early withdrawal penalty on your 401(k) loan's outstanding balance. So if you take out a $15,000 loan from your 401(k) and end up not repaying $10,000 of it, you'd be looking at a $1,000 penalty if you're under 59 1/2.

Consider your alternatives first

A 401(k) loan might seem like a good way to borrow, but the danger lies in not being able to repay your loan and the short repayment window that gets triggered even if you're laid off at work through no fault of your own. For this reason, you may want to consider alternative ways to borrow.

If you have good credit, a low-interest personal loan could be a good option. You can also look at borrowing against your home equity via a loan or line of credit (though do be aware that defaulting could put you at risk of losing your home).

If you do decide to take out a 401(k) loan, aim to borrow as little as possible. Review your budget carefully and make sure any payment you're on the hook for is one you can swing.

A 401(k) loan isn't always a bad decision. In some cases, it could be the easiest and least expensive way to borrow money. But before putting a 401(k) loan in place, make sure you understand exactly what you're signing up for and the risks you may be taking on.

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