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Ask Kim

Weigh the Pros and Cons of 401(k) Loans

The interest you pay yourself on money you borrow may not match what you could earn if the money stayed invested.

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I’m thinking about taking a loan from my 401(k). Is this a good idea? Does the Federal Reserve’s interest-rate increase affect 401(k) loans? --J.P., New York

See Also: 10 Things You Must Know About 401(k)s

The Fed’s rate hike, and any further increases, will affect new borrowers. Most 401(k) plans charge the prime rate plus one percentage point, and some charge prime plus two points. The prime rate rose from 3.25% to 3.5% in December. Rates on existing loans will not change.

With a 401(k) loan, you borrow your own money and pay the interest back to your account rather than to a lender. But consider the costs when comparing loan options. Some people reduce or stop contributions to their account while they’re repaying the loan. If you leave your job, you generally have to pay back the loan within 30 to 60 days of your last day on the job or you’ll owe taxes on the balance plus a 10% penalty if you’re younger than 55.

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Also, the interest you pay yourself on the money you borrow may not match what you could earn if that money stayed invested in mutual funds in your account. Most 401(k)s take the loan amount proportionately from each of your funds. You can minimize the impact by rebalancing your portfolio to shift more money from fixed-income funds into stock funds and consider the loan repayments as a fixed-income investment, says Marina Edwards, of Towers Watson, a human resources consulting firm.

See Also: 10 Things You Must Know About Roth Accounts

Got a question? Ask Kim at askkim@kiplinger.com.