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What is a 401(k) Loan and Is it a good idea?
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What Is a 401(k) Loan and Is it a Good Idea?
A 401(k) loan can derail your retirement savings. Weigh the risks and consider other options for financing.
Last updated on January 31 2023.
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Takeaways from Nerdy
The common 401(k) plan permits you to borrow up to 50% of the balance for up to five years with a maximum limit of $50,000. The cost to borrow is relatively low, and the interest paid will be returned to the person who borrowed the money. When you borrow money, you miss out on potential gains on stocks and accruing interest that can increase saving for retirement. The 401(k) loan is best looked at after all other options have been exhausted.
A lot of 401(k) plans permit participants to take out loans against their retirement savings. It's a low-interest loan option that can help pay for a significant expense, but tread lightly. A 401(k) loan can mean permanent retirement losses or even penalties if you're unable to repay the loan.
What is an 401(k) loan?
Employer regulations vary, but 401(k) plans generally permit users to borrow as much as half of their retirement account balance , or $50,000, whichever is less -- for a maximum of five years.
After other borrowing options are not feasible then a 401(k) loan might be an acceptable choice for paying off high-interest debt or covering a necessary expense, but you'll need a disciplined financial plan to repay it on time and stay clear of penalties.
Pros and pros and 401(k) loan
Consider the pros and cons before taking out a loan.
Pros
401(k) loans usually have single-digit interest rates, making them less expensive that credit cards. In general, interest is equal to one percentage point.
The interest you earn goes to your account.
There's no credit screening or impact to the score of your credit.
Cons
It can derail the retirement funds you have saved, often dramatically.
If you decide to quit your job, you must pay back the loan quickly.
Risks include tax consequences and penalties.
The true price of a 401(k) loan
Any money you borrow from your retirement fund misses both market gains and the magic that is compound interest.
Based on the study , borrowing $10,000 from the 401(k) plan over five years would mean sacrificing a $1,989 investment return and ending the five years with a debt of $666 lower. This assumes you have to pay 5% for the loan and the investments in your plan earned an average of 7%.
But the cost to your retirement savings account doesn't end there. If you've got 30 more years to retire, that missing $666 could have grown to $5,406, based on NerdWallet's (assuming the same 7% return, compounding every month).
Additionally, you can lower your 401(k) contributions as you make payments on an loan through the program. This can further reduce your retirement savings.
401(k) loans are tied to the company you work for.
If you leave your job while repaying your 401(k) loan, you have to pay the balance in a single day or within shorter time frame. Some policies require immediate payment if you leave before the loan is paid.
If you are unable to pay back the loan, the IRS will consider the unpaid amount to be a distribution and will count it as an income item when filing the year's taxes. Additionally, you'll be charged a 10% early withdrawal penalty if you're less than 59 1/2.
Do you want to use the 401(k) loan to pay off the debt?
Before you take out a 401(k) loan to pay off debt, think about alternatives that won't affect your retirement savings.
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Debt consolidation lets you roll several high-interest debts to a balance-transfer account or personal loan with a lower interest rate. Then you only have one monthly debt payment , and less the total cost of interest.
Options for debt relief If you're unable to pay off debts with no repayment options such as credit cards, personal loans and medical billsin the next five years or if the total debt equals more than half of your earnings it could be necessary to consolidate. Your best option is to speak with an attorney or credit counsellor about , including credit counseling.
Bankruptcy: Chapter 13 bankruptcy and debt management plans are required for five years of payments minimum. Then, the remaining debts from your consumer are wiped out. Chapter 7 bankruptcy discharges consumer debt immediately.
Unlike consumer debt, a 401(k) loan isn't forgiven in bankruptcy.
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401(k) loan alternatives
Due to the risks that come with 401(k) loans, first think about other options for financing.
Alternatives for large expenses
Personal loans are a great option to use to pay for everything, including debt consolidation, home repairs or emergencies, medical bills and medical expenses. The loan amounts range from $1000 to $100,000 and the interest rates are 6% to 36 percent. The loans are usually paid in monthly installments, over a period of between two and seven years.
These loans are unsecured, so you don't need collateral. A lender uses the information from your credit and financial records to determine whether you qualify and the interest rate per year.
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Find out if you're pre-qualified for an individual loan - without affecting your credit score
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The amount of the loan
on NerdWallet
Equity home loans and lines of credit The line of credit or home equity loan or line of credit is a cost-effective way to cover urgent home repairs or other emergencies. Depending on which you choose the best option, you could typically get as much as 80% your house's worth, less the amount you owe on the mortgage. Rates tend to be in the single-digits, and repayment terms range between 10 and 20 years.
The home equity loans and credit lines will require you to pledge the home you live in as collateral to secure the loan which means that the lender has the right to accept it in the event that you fail to repay. The main difference between these types of financing is the borrow-and-repay structure.
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0% APR balance transfer credit card: Another alternative is to shift the high-interest debt into a credit card that has no-interest promotional time. It is generally necessary to have good or excellent credit to be eligible (690 or higher credit score) and the amount you're able to transfer is contingent of the maximum credit amount the card issuer gives you. If you qualify, you will have to pay the balance during the interest-free promotional period -typically 15 to 21 months to avoid paying the card's (often high) regular APR.
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Alternatives to pay for the smallest of expenses
You can ask an amiable friend or family member to take out a loan to to bridge a gap in income or cover an emergency. There's no credit verification for this loan option, and you can draw up a contract with the lender that outlines the amount of interest charged and how the loan will be repaid.
: Cash advance apps allow users to borrow as much as one hundred dollars, and then pay back the loan on their next payday. These advances are an efficient way to cover a small, urgent expense. There's no interest. However, these apps usually add fees to fund fast and ask for optional tips.
When you're working on repairing the car, replacing a laptop or purchasing a mattress, the merchant may offer buy nowand plan to pay in the future. This type of payment plan lets you divide a purchase into smaller, typically biweekly installments. Having bad credit (a score below 630) may not prevent you from qualifying because there's usually only a soft credit check.
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About the writer: Annie Millerbernd is an individual loans writer. Her writing has been featured on The Associated Press and USA Today.
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