How Interest Rate on a 401k is Calculated

Believe it or not, you can actually lend money to yourself. It's true, and it can be much, much cheaper than a credit card -- though that doesn't necessarily make it a good idea. You can take a loan out from your own 401(k) retirement account, and pay it back to yourself with interest. While it would be nice to give yourself a no-interest loan (especially considering this is your money), the world just isn't that fair.

Whether taking a loan out of your 401(k) is a good idea or not is a matter for much debate, but it largely depends on your financial situation and your employment stability. The biggest downside to taking such a loan is that, should you lose your job, you are required to pay the loan back in full within 60 days or else risk paying penalties and taxes (once you have defaulted, the loan is treated as an early withdrawal). Furthermore, financial planners will point out that taking principal out of your retirement account will make it grow more slowly, and that's hard to argue with.

But if your employment situation is stable, you still earn some interest on the money you've taken out of your account, although you are the one paying the interest into it.

What is a 401(k) Loan?

The terms of a 401(k) loan are set by employers, not by you or the fund administrators, so there is no standard here except for what is legally permissible. You can take out up to 50% of your retirement fund (or $50,000, whichever is smaller) as a loan, which can be repaid over a maximum term of 5 years (with some exceptions) and is typically taken out of payroll (as an after-tax payment, it's worth noting). And despite what people say, you don't really pay tax twice on a 401k loan -- according to some.

It's a strange and complex financial product. Some have even pointed out that it is, technically speaking, a means of diversifying your investments -- even if you're the source of the interest payments. And for an emergency loan (or a loan for someone with damaged or no credit), a 401k loan can have attractive interest rates.

What Determines the Interest Rate?

Typically, according to most sources, a 401(k) loan will carry an interest rate based on the Prime Rate plus 1 or 2 percentage points. The prime rate is published every day by the Wall Street Journal, based on surveys of 30 banks' lending rates.

Its low rates are comparable only to a HELOC, which, if you don't have any home equity to tap into, you can't get. And unlike with HELOC, you're actually paying yourself the interest -- not your bank.

How to Pay Off 401(k) Loan

This is the number one use for tapping your 401(k). Typically, your 401(k) loan tacks on 1% interest to the prime rate.

So, figure on paying yourself back at 4.25%, which is vastly superior to the interest rates (on average from 13 percent to 22 percent) that banks charge their credit-card happy customers.

Should You Use 401(k) to Cover Emergency Expenses?

Life is filled with emergencies. Even if you have medical insurance, your carrier likely won’t pick up the entire tab.

If you had an open home equity line of credit, you might be tempted to tap those funds first. HELOC rates may be very close to what you'd get from a 401(k) loan. And, a HELOC may be tax advantaged (tax deductible on up to $100,000 for expenses that don't deal with your home).

But if you don’t have one, there’s all that initial paperwork to fill out. Plus, HELOCs adjust monthly, usually with no limit on the size of the adjustment.

Caution: You could lose your home if you fail to repay the borrowed funds through your HELOC.

To Cover Educational Costs

While average student loan debt is about $20,000 per graduate, many alumni are carrying heavier debt loads at even higher percentage rates. So, if you have the opportunity to pay off a nagging student loan at, say, 7% APR or higher, you should kill it off, no questions asked, using your 401(k).

By the way, if you’re curious why the IRS makes you pay yourself back with interest, credit the bureaucrat who didn’t want you to entirely gut whatever retirement savings you had managed to scrape together. Paying yourself back with interest softens the blow of self-borrowing.

To Pay For a Special Occasion

If you don’t have a war chest or emergency fund to raid for a special event, you should consider tapping your 401(k). When we say “special event,” we don’t mean running out to buy a 70-inch high-def television set, either.

We had in mind maybe an engagement ring (average cost of 5,000) or even a wedding (average cost of $18,000). Again, you don’t have to turn to any super calculator to see how you might come out ahead. If the cost of interest charged on a consumer loan is 8 percent and the investment earnings you lose from your 401(k) withdrawal is 7 percent, you gain a 1 percent cost advantage.

Things to Consider

First, if you have to raid your retirement savings for any reason, you need to take a hard look at what brought you to this fiscal cliff. Have you been spending too much? Are you not following your budget? Do you even have a budget for living expenses, including a rainy day fund to cover life’s emergency of the month?

Second, when you begin repaying yourself back, you still need enough cash flow to afford your other payments such as your mortgage and car payments.