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401(k) Loans vs. Personal Loans: What to Know Before You Borrow

401k loan vs personal loan
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updated: July 3, 2024

When you need cash, there are a few different directions you can turn—and two of the most common are 401(k) loans and personal loans. While both options can help you access money in the short term, each has advantages and drawbacks to consider before you make a decision.

And both carry risk when not used with forethought and care. Here’s what you need to know to make the final decision in the 401(k) loan versus personal loan debate.

401(k) loan vs personal loan: Key differences

Here are some key differences between 401(k) loans and personal loans, at a glance.

401(k) LoanPersonal Loan
Interest rates
One or two percentage points over the prime rate—and you’re ultimately paying interest to yourself
Range widely but can be as high as 35.99%
Loan amount
Generally, the lesser of 50% of your savings, or $50,000
Loans available from $1,000 to $100,000
Term
In most cases, the loan must be repaid within five years
Some lenders offer terms as long as 12 years
Availability
Depends on your employer and the specific plan you have access to
Available to any qualifying applicant

What is a 401(k) loan?

A 401(k) loan is exactly what it sounds like—a loan you take out against the balance of your 401(k) retirement plan. Since you’re borrowing from yourself, you’re technically on both sides of the table—which means the money you’re paying back to the account remains your own. That means 401(k) loans can be less expensive than personal loans in the long term, if you can repay them.

If you fail to repay a 401(k) loan, where the loan term (i.e. repayment period) is typically limited to just five years, the loan will be considered a withdrawal instead, which means you’ll be liable for both regular income tax on the money, as well as the 10% early withdrawal penalty (unless you’ve reached age 59½).

Furthermore, if you leave or lose your job before the loan is repaid, you may suddenly be on the line to pay it in full on a much shorter timeline—perhaps just a few months. Remember that not every employer or custodian allows 401(k) loans as part of their retirement plan (and even if they do your maximum loan amount and term may be even more sharply limited).

401(k) loans are different from hardship withdrawals, which are permanent withdrawals (based on demonstrated qualified financial need) taken out of your retirement plan before you reach retirement age. These needs may include avoiding foreclosure on your home, medical expenses, or tuition expenses, among others—but even if you qualify for hardship withdrawals, you may still need to pay income taxes and the early withdrawal penalty.

401(k) loan pros and cons

Here’s a closer look at the pros and cons of 401(k) loans.

Pros:

  • Lower interest rates. 401(k) loans are usually available with rates one or two percentage points above the prime rate, which means they’re generally in the single digits.
  • Interest is going back to you. Although paying interest toward your 401(k) loan might be a challenge in the short term, in the long term, it’s going back into your pocket in retirement.
  • No credit check is required. Because you’re borrowing money from yourself, there’s no need to prove your creditworthiness to a third-party lender (or endure a hard credit inquiry).

Cons:

  • Not available to everyone. Only those with access to an employer-sponsored 401(k) plan can consider a 401(k) loan, and not all plans allow these loans in the first place.
  • Lower loan cap. 401(k) loans max out at 50% of your savings or $50,000 over 12 months, and your plan custodian may limit this even further.
  • Shorter terms. Most 401(k) loans have to be repaid within five years.
  • Loss of growth opportunity. The money you borrow from your 401(k) will not be subject to compound interest during the loan period, which could lower your long-term retirement total.
  • Risk of default. If you don’t repay your loan in time—including if you lose or leave your job and the loan becomes due much sooner—you may be on the line for both income tax and the 10% early withdrawal penalty on the funds.
  • Lower paychecks. 401(k) loan repayments are often deducted directly from your paycheck, which means the amount you see on payday will likely be lower than you’re used to.

What is a personal loan?

A personal loan is a flexible, unsecured loan—meaning there’s no collateral required—that allows you to use the funds you borrow in just about any (legal) way you please. Many people take out personal loans to consolidate existing debt (to fast-track payoff) or for unforeseen emergency expenses, like medical bills.

Personal loans can also be used for vacations, weddings, and other events, but going into debt for fun is usually less advisable than doing so because you have to.

Personal loans are borrowed from lending institutions, like banks and credit unions; in most cases, the money is paid upfront as a lump sum as soon as the application is processed and approved. The borrowed amount is then repaid over the loan’s term, which, in the case of privately offered personal loans, can be much longer than 401(k) loans—sometimes as long as 12 years.

Loans are repaid in regular monthly installments of a set amount, including the principal (the amount borrowed) and interest (the amount charged for the service of offering the loan). Personal loans tend to come at far higher interest rates than 401(k) loans, and the interest goes to the bank—not back into your pocket.

Personal loan pros and cons

Here’s a quick look at the drawbacks and benefits of personal loans.

Pros:

  • Availability. Personal loans are available to anyone who can qualify for them, whether or not they have access to an employer-sponsored retirement plan.
  • Flexibility. Personal loans offer far more flexibility in terms of loan amount and repayment term than 401(k) loans.
  • Ease of application. Many providers offer personal loans, and many applications can be completed online in just a few minutes.
  • Doesn’t (necessarily) affect your retirement savings. A personal loan is entirely separate from your retirement account, and aside from the payment narrowing your discretionary income each month (which might require you to divert funds you’d otherwise contribute to your retirement account), taking out a personal loan shouldn’t affect your retirement savings one way or another.

Cons:

  • Costlier than 401(k) loans. Personal loans are offered by for-profit financial institutions and often come with higher interest rates, even for very qualified borrowers.
  • Interest isn’t coming back to you. The interest you pay on a personal loan goes into the bank’s pockets, not yours.
  • Harder to qualify for. Personal loans are restricted to those who meet eligibility criteria, which can sometimes be higher than those of secured loans.
  • A hard credit check is required. Banks will pull your credit report to ascertain your eligibility to borrow.
  • Other fees may apply. Depending on your lender, your personal loan may also be subject to origination fees, late fees, and early repayment penalty fees—so always read the fine print.

When is a 401(k) loan the right choice?

If you feel confident you’re going to stay at your job for a long time, have ample retirement savings (and, ideally, ample time before you retire), and can afford to repay the loan in a shorter time frame if you should unexpectedly lose your job, a 401(k) loan may be the right choice for you.

When is a personal loan the right choice?

If you don’t have access to a 401(k) at work (or your plan doesn’t allow loans), have just gotten started on saving for retirement, need a larger amount than your 401(k) loan plan allows (or more time to repay the loan), and have the credit score and eligibility profile to qualify for one, a personal loan may be the right choice for you.

TIME Stamp: Use caution when taking out a personal or 401(k) loan

While personal and 401(k) loans can help you access cash, both can be risky if you don’t exercise caution and restraint. For instance, 401(k) loans could lower the total of your future retirement nest egg, while high-interest-rate personal loans could make it more difficult to save money for any financial goal. Still, in some cases, these products can help people reach worthy short-term financial goals, like paying off debt, making home renovations, or paying off medical bills.

Frequently asked questions (FAQs)

Is a 401(k) loan better than a personal loan?

A 401(k) loan isn’t better or worse than a personal loan—it’s just different. In a 401(k) loan, you temporarily take money out of your 401(k) retirement plan with the promise to repay it, plus interest, over the course of (not more than) five years, in most cases.

While this means you avoid paying interest to a third party (like a bank or a credit union), it can reduce your cash flow and impact your ability to earn compounding returns in your retirement account. On the other hand, personal loans can be costlier (thanks to higher interest rates and longer loan repayment periods). It all depends on your personal needs.

What is the downside of a 401(k) loan?

There are several downsides to 401(k) loans. For starters, there’s the opportunity cost of taking money out of your investment account even temporarily; those funds might have grown substantially over the period of the loan thanks to compound interest, but they won’t if they’re liquidated as cash.

Furthermore, if you fail to repay your 401(k) loan in time, the defaulted loan will be treated as a withdrawal; you’ll owe income tax—plus a 10% early withdrawal penalty on the amount. Plus, you may be required to repay the loan suddenly if you unexpectedly lose your job.

Does a 401(k) loan go against your credit?

This is one of the biggest benefits of a 401(k) loan: It does not affect your credit whatsoever, even if you default on the loan. While you’ll be on the hook for income taxes and possibly an early withdrawal penalty, you won’t have to worry about messing up your credit score if you can’t pay your loan back in time. Furthermore, there’s no credit check required to start up the loan in the first place.

Should I borrow from my 401(k) to pay off debt?

Only you can decide if borrowing from your 401(k) to pay off debt is a sensible financial decision in your specific circumstances. If debt is making it difficult to save money or achieve other financial goals, a 401(k) loan may be one way to help alleviate the burden.

However, because taking out a 401(k) loan can lower your available retirement funding, looking into other sources before raiding your nest egg is usually worthwhile. Using a personal loan to consolidate debt is another option that helps many people kick-start their debt repayment process.

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