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Keep Funding Your Account

Lessen the impact of a 401(k) loan by continuing to contribute while repaying the loan.

New research from the Federal Reserve suggests that borrowing from a 401(k) may make sense if the interest rate you would pay for an alternative loan, such as a car loan or a credit card, is higher than the rate of return you expect to earn on investments inside your 401(k) account.

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A 401(k) loan, handled properly, could be the least costly source of funds, according to economists Geng Li and Paul Smith. And they predict that the recent tightening of terms in mortgage and consumer lending will boost 401(k) borrowing. But handled improperly, borrowing from your 401(k) can inflict major damage on your long-term savings. The key is whether you continue to contribute to your 401(k) plan while you repay the loan.

Say you have $40,000 in your 401(k) plan earning an average annual return of 7%. (Yes, such returns, or even higher, are possible now that the stock market has started to recover from the lows it reached in March.) Also assume that you contribute $200 a week to your 401(k). If you borrow $20,000 from your plan at 5% interest and repay it over five years -- but you stop contributing to your plan in the interim -- that loan will cost you more than $365,000 in lost savings by the time you retire in 30 years. However, if you continue to contribute your usual $200 a week while you make the loan payments, the long-term impact on your savings will be less than $8,000.

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