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 what a 401(k) loan is and does, and how it compares to a personal loan.
What is a 401(k) Loan?
A 401(k) loan is something generally offered by employers that lets you essentially 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 this1
- Have enough in the account to borrow against (you can take up to half out in a loan, up to $50,000)2
- Plan to be an active employee for the entire loan term unless you want to pay back the loan at once3
- Be willing to take paycheck deductions4
Sources: (1) MotleyFool (2) IRS.gov, (3) CNBC.com (4) FINRA.org
Why is a 401(k) Loan Good?
One main advantage to 401(k) loans is that you don’t pay interest to a lender.
However, you do pay interest—but to yourself. This means that, usually, each paycheck has a small deduction that goes back into your 401(k). The payment includes both principal payments as well as 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) withdraws if you’re younger than 59-and-a-half unless you meet certain exceptions. Further, the withdrawals are taxed as normal 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
- Major purchases
- 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 fast and can be 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 the rates will be different than under a 401(k) loan, depending on the lender.
However, if tampering with your retirement makes you squeamish, it might be worth looking into a personal loan.
Look 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.
Both 401(k) loans and personal loans can bring essential resources, but they can also affect your financial well-being long-term. 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.
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