If you need funds quickly and can meet the requirements, a 401(k) loan can be a flexible, inexpensive borrowing option. But these loans come with strings attached that often don’t apply to other forms of lending, such as personal loans.
Considering borrowing against your retirement savings to fund a short-term expense? Here's a high-level overview of a 401(k) loan vs. a personal loan.
Quick Summary
- A 401(k) loan lets you borrow from your own retirement savings — no credit check required, and the interest goes back to you.
- A personal loan is issued by a bank or lender and repaid with interest over a set term, usually 2 to 7 years.
- Personal loans are better if you need to repay for more than 5 years, or you don't want to risk your retirement savings.
- According to the IRS, you can borrow up to 50% of your vested 401(k) balance or $50,000, whichever is less.
What is a 401(k) Loan?
Employers generally offer a 401(k) loan and let you borrow from your own retirement savings.
To take out a 401(k) loan, you usually must:
- Work for an employer that allows you to do this
- Have enough in the account to borrow against (and according to the IRS, you can take up to half out in a loan, up to $50,000)
- According to CNBC, you should plan to be an active employee for the entire loan term unless you want to pay back the loan at once
- Be willing to take paycheck deductions
Why is a 401(k) Loan Good?
One main advantage of 401(k) loans is that you don't pay interest to a lender.
However,
you do pay interest—but to yourself. This means that, in most cases, each paycheck has a small deduction that goes back into your 401(k). The payment includes both principal and interest.
Further, another 401(k) loan advantage is that there's no credit check for a 401(k) loan and no inquiry against your credit report. The funds generally come relatively quickly, and sometimes you get issued a convenient debit card.
If you don't want to borrow your own money, a 401(k) withdrawal is often another option--although seldom a very good one. The main reason for this is that there's a 10% penalty on 401(k) withdrawals if you're younger than 59-and-a-half, unless you meet certain exceptions. Furthermore, withdrawals are taxed as ordinary income.
The Disadvantages of a 401(k) Loan
While cutting out the lender may seem like a winning proposition, there are some drawbacks to 401(k) lending.
For one, you may lose out on potential investment gains. Although you’re technically paying yourself interest, the money you borrowed isn’t growing passively like it could in your 401(k).
It’s also important to remember that if you leave your employer while you’ve got a 401(k) loan outstanding, in most cases, you'll have to pay that loan back all at once.
What Can You Do with a 401(k) Loan?
401(k) loans are generally short-term, so you can use them for almost anything you can pay off in less than five years, such as:
- Home renovations
- Home down payments
- Medical expenses
- Vacations
- Major purchases
- Weddings
- An emergency
Is a Personal Loan a Good Alternative to a 401(k) Loan?
There are several alternatives to 401(k) loans, including home equity loans, credit cards, and personal loans.
A
personal loan is a loan that you pay back through monthly installments. Like 401(k) loans, personal loans can be originated relatively quickly and used for many purposes.
Unlike 401(k) loans, however, personal loans do not dip into your retirement savings. As such, you do not risk losing market gains that could delay or prohibit your planned retirement.
Also, 401(k) loan restrictions do not apply to personal loans. So, for instance, if you don’t think you’ll be working at the same organization for the length of the loan, you might consider a personal loan instead.
The disadvantages of this alternative are that you'll have to pay interest and fees to the lender, have a credit inquiry on your record, and that the rates will differ from those under a 401(k) loan, depending on the lender.
However, if tampering with your retirement plan makes you squeamish, it might be worth considering a personal loan.
Frequently Asked Questions:
Does taking a 401(k) loan hurt your credit score?
Answer: No, a 401(k) loan does not require a credit check and is not reported to the credit bureaus, so it will not directly lower your credit score. However, if you default on the loan and it is treated as an early withdrawal, the resulting tax bill could affect your overall financial health.
What happens to my 401(k) loan if I lose my job?
Answer: If you leave your job, whether voluntarily or due to a layoff, you may be required to repay the full remaining balance of your 401(k) loan by the tax-filing deadline for that year. If you cannot repay it, the outstanding amount is treated as a taxable distribution. If you are under 59½, you may also face a 10% early withdrawal penalty.
How much can you borrow from your 401(k)?
Answer: According to
IRS rules, you can borrow up to 50% of your vested 401(k) balance or $50,000, whichever amount is less. Your specific plan may have additional restrictions, so check with your plan administrator before applying.
Can you pay off a 401(k) loan early?
Answer: Yes, most 401(k) plans allow you to repay your loan early without a penalty. Paying it off ahead of schedule means your money returns to your retirement account sooner and can resume earning investment returns.
Look at both short and long-term.
Retirement can seem so far away, especially when you need funds ASAP. But when the day comes to stop working, you’ll likely want as much retirement savings as possible.
The right choice between a 401(k) loan and a personal loan depends on your credit situation, job stability, and how urgently you need the funds. If you have a stable job and limited credit options, a 401(k) loan can be a low-cost way to access cash, but only if you're confident you can repay it. If you need a longer repayment window, a personal loan gives you more flexibility without putting your retirement at risk. Either way, it's worth comparing your real options before making a decision.
Speaking to a financial advisor before making decisions that could delay your retirement is usually a good idea. In any case, before you borrow any money, know what it might cost you in the long run.