When you need money fast, you might wonder, what’s better when comparing a 401K loan vs personal loan? Both options offer funds in a relatively short timeline, but which is better for your needs?
Here’s everything you need to know about 401K and personal loans to help you answer the question, should I borrow from my 401k?
Is It Better to Take a Personal Loan or Borrow From 401K?
Personal and 401K loans have the same result – they provide access to funds you need for a larger purpose. However, whether it’s better to take a personal or 401K loan depends on the use of the funds, the interest rates, and how quickly you can access and repay the funds.
You should also consider your long-term financial goals when deciding if it’s right to borrow from your 401K.
Related Article: Personal loans from top lenders. All in one place.
Understanding What a 401K Loan Is
A 401K loan is a loan from your employer-sponsored retirement savings account, not a lender. As a result, you don’t have to go through the typical loan approval process, and you can typically access your funds in a few days or less.
However, not all employers allow 401k loans and may have different 401k loan terms regarding how much you can borrow and what they’ll charge. For example, the most you can borrow from any plan, no matter the employer’s rules, is the lesser of 50% of your balance or $50,000, but some employers have lower loan limits.
Employers that allow a 401K loan typically doesn’t restrict how you can use the funds. However, common uses are for a down payment on a house, home renovation or repairs, paying medical bills, or to consolidate debt.
Here are the most important facts; You must repay a 401K loan. It sounds crazy because you’re paying yourself back, but it’s the law. If you don’t, you risk paying an early withdrawal penalty and taxes on the amount withdrawn.
When you repay a 401K loan, you repay yourself, including interest. Most employers require monthly or quarterly repayment. You can usually have the funds automatically withdrawn from your paycheck. Typically, you have a maximum of five years to pay the loan in full, but you can also pay it early without prepayment penalties.
Understanding What a Personal Loan Is
A personal loan is a loan from a bank that’s usually unsecured. This means there isn’t any collateral to guarantee the loan. You must qualify for an unsecured personal loan with your credit history and income to prove you can repay the loan.
Lenders offer personal loans in amounts of $500 to $100,000, but the average personal loan is usually only a few thousand dollars. If you need a much larger loan, you may need to put up collateral to guarantee the loan.
You can check out your options on Credible to see what terms you can get from lenders. To get prequalified, you can enter some simple information about your loan needs and credit and see what offers you receive. The marketplace makes it simple to compare offers side-by-side to ensure you get the best rate. It’s free, and checking rates doesn’t hurt your credit.
Credible doesn’t sell your personal information to other lenders or competitors, and you’ll receive personalized quotes based on your credit score, not estimates.
The good news is that personal loans can be used for any purpose. Still, the most common reasons are debt consolidation for high-interest debt, which can reduce interest payments, home renovations, and covering a large, unexpected expense.
Personal loans often have a fixed interest rate. However, you must make monthly payments for the entire term, typically 2 – 5 years. Your credit score will determine the rate you pay. Borrowers with lower credit scores often pay higher interest rates than those with better credit scores.
If you have late or missed payments, it can hurt your credit scores, and the lender could start the collection process against you. If you put up any collateral for the loan, you risk losing it if you don’t make your payments.
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401K Loan vs Personal Loan
When comparing the 401K loan vs personal loan, you should consider the pros and cons of each.
Key Pros and Cons of 401K Loans
401K loans have benefits; even though it’s risky to borrow money from your future, there are times when it may make sense and times when you should consider your other options.
The Pros of 401K Loans
- The 401K loan rate is usually lower: 401K loans often charge lower interest rates than you’d pay on personal loans or credit cards.
- You earn the interest: When you pay your loan back with interest, the full amount goes back into your 401K account instead of to a lender.
- You don’t have to qualify for the loan: Your employer won’t do a credit check or calculate your debt-to-income ratio.
The Cons of 401K Loans
- The risk of penalty fees: If you don’t repay a 401K loan in time, you could risk paying a 10% early withdrawal penalty plus taxes.
- Full debt repayment required: If you leave your job, you may be required to pay the loan in full within a few months.
- Lose compound earnings: When you withdraw funds from your 401K, you lose the compound earnings you could have earned if the money remained in the account.
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Key Pros and Cons of Personal Loans
Like a 401K loan, there are personal loan pros and cons you should consider.
The Pros of Personal Loans
- No risk to your retirement account: Personal loans don’t affect your retirement savings, so you won’t lose the compound earnings on your retirement account.
- No withdrawal penalty: You don’t have to worry about facing an early withdrawal penalty.
- Option to shop around: You can shop around for a personal loan to get the best rates and terms. You may even find lenders that fund the next business day.
The Cons of Personal Loans
- Higher interest rates: You’ll likely pay higher interest rates on personal loans, and the interest goes to the lender, not you.
- Hurts your credit: A new personal loan can hurt your credit, and if you don’t make the payments on time, you can damage your score further.
- You may pay fees: Many banks charge an origination fee or have other costs for borrowing a personal loan.
401K Loan Repayment Rules and Options
Before borrowing money from your 401K, you must know the rules and options to ensure it’s the right choice.
Typically, you can choose your repayment schedule from various options. Each employer can set individual requirements, but on average, you can choose from the following:
- A Monthly payments
- An Automatic paycheck withdrawals
- A Lump sum repayment
The key is to choose the option you know you can adhere to because if you don’t repay the loan, you may face penalties.
However, if you leave your job, you may be required to pay the loan much faster. Usually, you have only a few months to pay the full balance back, and if you don’t, you may face penalties.
Penalties for Borrowing From Your 401K
The largest risk with borrowing against your 401k loan occurs when you don’t pay it back. This could mean you didn’t pay the full balance back within five years or quit your job and didn’t repay the loan.
In both situations, the IRS considers it an early withdrawal which makes it subject to early withdrawal penalty fees of 10%. You’ll also pay after-tax dollars on the amount considered a withdrawal.
401K Loan Interest Rate Facts
Typically the interest rate on a 401K loan is a point or two higher than the prime rate. Your 401k plan rules determine the exact rate you pay. However, you must pay the principal plus interest back to avoid the early withdrawal penalties.
Typically, the interest rate you pay is less than the rate of return you’d receive on your 401K funds if you left them untouched, so you lose the compound earnings you’d have if you left the funds in your 401K account.
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Personal Loan Repayment Rules and Options
Personal loans have different repayment rules and options. They always require a monthly payment, but you may have a choice of different rates and terms, especially if you shop around for the best deal.
Most personal loans charge a fixed interest rate. This means your payment is the same each month, and a portion of your payment goes to interest, and the rest pays down the principal balance. So as you get further into the loan term, you pay less interest than the principal.
Always read the fine print because personal loans sometimes charge origination fees to get the loan or prepayment penalties if you pay the loan early.
Does Taking a Loan From Your 401K Hurt You?
Borrowing your 401K isn’t the best idea because it takes money from your retirement plan. In addition, if you take the full five years to pay the funds back, you could lose a lot of compound interest by not having the funds in your account. However, it may be your best option if you have an extreme emergency and no other way to get the funds.
Where Can I Find a Good Personal Loan?
You can find personal loans at your local bank, where you already have a banking relationship, or online. Most banks have an online personal loan application you can complete and get an answer quickly. Some of the most popular banks for personal loans include Citibank, Wells Fargo, and Discover.
Will My Employer Know if I Take a 401K Loan?
Your employer will know if you take a 401K loan, as they are the plan sponsor. While the plan administrator (usually a third party) manages the loan, your employer will likely know of the loan, but it shouldn’t affect your employment.
What Is the Difference Between a 401K Loan vs. Withdrawal?
When you withdraw money from your 401K, you don’t repay it. If you withdraw funds before age 59 1/2, you will pay a 10% penalty plus applicable income tax at your current tax rate. A 401K loan requires repayment. If you repay it within the five-year term, you don’t pay any penalties. The only charge you’ll pay is the interest plus any administrative fees the plan administrator charges.
Who Gets the Interest on a 401K Loan?
The interest you pay on a 401K loan goes back to your retirement savings account. So while paying interest, you aren’t paying a bank or lender the money. Instead, it goes back to you.
How Do You Borrow Against Your 401K?
To borrow from your 401K, you must contact your plan administrator. They will tell you the process for their program, including the necessary documentation and timeline to receive the funds.
How Many Times Can You Borrow From 401K?
Most employers only allow you to have one 401K loan at a time. After that, you can apply again if you need money after repaying the loan. Each employer has different rules regarding how often you may borrow money from your 401K.
Choosing a 401K loan vs personal loan is a big decision. Borrowing against your 401K affects your retirement savings, but a personal loan may not be an option if you don’t have a good credit report and average debt-to-income ratio.
It’s important to weigh your options, look at the total cost of both loans, and choose the one that costs the least in the long run. If you decide a personal loan is the way to go, get prequalified on Credible for free, and see how much you’re qualified to receive.
Samantha Hawrylack is a personal finance expert and full-time entrepreneur with a passion for writing and SEO. She holds a Bachelor’s in Finance and Master’s in Business Administration and previously worked for Vanguard, where she held Series 7 and 63 licenses. Her work has been featured in publications like Grow, MSN, CNBC, Ladders, Rocket Mortgage, Quicken Loans, Clever Girl Finance, Credit Donkey, Crediful, Investing Answers, Well Kept Wallet, AllCards, Mama and Money, and Concreit, among others. She writes in personal finance, real estate, credit, entrepreneurship, credit card, student loan, mortgage, personal loan, insurance, debt management, business, productivity, and career niches.
Saturday 25th of March 2023
I'm not sure if it is still the case but in the 401K plan I helped manage at my employer you could not contribute to, or get the employer match for contributions as long as a loan was outstanding. Missing out on that free money and on the chance to make regular contributions to your 401K made taking a loan a very bad deal for most employees. It was painful to watch people get those loans for a vacation or a new pickup truck. They really were sacrificing their future for something they could have done without.
Sunday 26th of March 2023
Wow, I had never heard of that. But Google says it's a thing too - definitely something else to review if you're considering!