Personal Loans
If you need funds to pay for short-term expenses, 401(k) loans and personal loans are two options worth considering. A 401(k) loan allows you to access a portion of your retirement savings, and a personal loan lets you borrow from a lender. While it’s generally a better idea to take out a personal loan so you can grow your 401(k), whether it makes more sense to take out a 401(k) loan vs. a personal loan depends on your particular needs and situation.
Key Takeaways
A 401(k) loan allows you to borrow against your retirement savings. With this type of loan, you are both the borrower and the lender.
A personal loan usually doesn’t require collateral and can be used to consolidate debt, finance a major purchase or fund home improvement projects.
Deciding between a 401(k) loan vs. a personal loan depends on your specific needs and circumstances. It’s smart to weigh each option’s benefits and drawbacks to make a wise financial decision.
What Is a 401(k) Loan?
A 401(k) loan is a loan you take out from your 401(k) retirement savings plan. Because you’re borrowing from your retirement savings, you essentially lend yourself money.
With a 401(k) loan, the maximum amount you can borrow is $50,000 or 50% of your vested account balance, whichever is lower. You can use the funds for debt consolidation, home renovations, medical bills, post-secondary education or other expenses.
When you take out a loan from your 401(k), you’ll sign a loan agreement that contains the term of the loan, principal, interest rate and associated fees. Typically, you have five years to pay back your loan. Repayment can be made through payroll deductions using your after-tax earnings.
If you quit your job or are laid off and default on your 401(k) loan, you will be taxed on your unpaid loan balance. You will also be subject to a 10% early withdrawal penalty if you are younger than 59 ½ years old.
Features of a 401(k) Loan
A 401(k) loan allows you to borrow up to $50,000 or 50% of your vested balance, whichever is less, and repay it in five years, with interest.
GENERAL QUALIFICATIONS
To borrow from your 401(k) plan, you must ensure your employer allows 401(k) loans and you have a vested account balance. If you’re married, you may need written evidence of spousal approval to take out a 401(k) loan. 401(k) loans don’t often involve credit checks, so you don’t need to meet any minimum credit score requirements to qualify for one.
INTEREST RATE
401(k) loans come with interest that’s one or two points above the prime rate. That means if the prime rate is set at 5.5%, your 401(k) loan rate would be between 6.5% and 7.5%.
REPAYMENT TERMS
According to the Internal Revenue Service, you need to repay your 401(k) loan within five years. Repayment must also include the principal and interest. If you use the money to purchase a primary residence, you may have more than five years to repay your 401(k) loan.
Pros and Cons of a 401(k) Loan
Although 401(k) loans offer a low-interest way to obtain funds, they may subject you to taxes and fees should you default on your payments.
- No credit checks: 401(k) loans don’t require credit checks or appear on your credit report.
- Lower interest rate: Because 401(k) loans don’t generate an inquiry against your credit, you may get a lower rate than you would on a different type of loan.
- The interest goes to you: The interest you pay on your 401(k) loan goes back into your retirement account. Basically, you are paying interest to yourself.
- Avoid taxes and penalties: Since you’re borrowing from your 401(k) instead of withdrawing, you won’t be subject to income tax or potential early withdrawal penalty unless you default.
- Low borrowing limits: 401(k) loans are limited to the lesser of $50,000 or 50% of your vested balance. That means you may only borrow half of what’s available in your retirement account.
- Missing out on potential growth: Getting a 401(k) loan means you’re taking out money from your retirement savings that’s growing tax-free. Even if you pay the money back, it will have less time to grow.
- Not all 401(k) plans permit loans: Some 401(k) plans prohibit you from borrowing against your account balance. Check with your employer and plan administrator if this option is available.
What Is a Personal Loan?
A personal loan is a sum you can borrow from a financial institution, such as banks, credit unions and online lenders. Personal loans are often unsecured loans, meaning there’s no collateral required.
Depending on your lender, you may be able to borrow up to $100,000 for personal expenses. These include debt consolidation, home improvements, major purchases, medical bills or vacation costs. Some lenders may also allow you to use your funds on post-secondary education.
Repayment terms also tend to vary per lender and loan amount. Lenders usually offer repayment terms ranging from one to five years.
Defaulting on your loan can have serious consequences. It can bring down your credit score and make it more difficult for you to qualify for new credit. If your loan is unsecured, your lender may take you to court or place a lien on your home. If your loan is secured, your lender has the right to seize any collateral you used to secure your loan.
Features of a Personal Loan
Before applying for a personal loan, consider its qualification requirements, interest rates and repayment terms to determine if it’s right for you.
GENERAL QUALIFICATIONS
The requirements to get a personal loan differ across lenders. Generally, lenders will consider your credit score, debt-to-income (DTI) ratio and income. To increase your chances of getting loan approval, ensure you have a good to excellent credit score and a DTI ratio below 43%.
INTEREST RATE
According to the latest data from the Federal Reserve System, a two-year personal loan has an average interest rate of 11.23%. That said, your interest rate will vary based on your creditworthiness, loan amount, length of the loan and lender.
REPAYMENT TERMS
Your repayment period dictates how long you have to pay off your loan. Usually, lenders offer repayment terms between 12 and 60 months. A shorter repayment term may be ideal if you want to save on interest. You’ll have higher monthly payments but lower interest in the long run.
Pros and Cons of a Personal Loan
Personal loans may be an ideal option for various financial purposes, but watch out for origination fees, prepayment penalties and restrictions on fund usage.
- Higher borrowing limits: Depending on the lender, you may be able to take out a personal loan of up to $100,000 for debt consolidation, home improvements or major purchases.
- No collateral: Most personal loans are unsecured, meaning you don’t have to use any asset you own to secure the loan.
- Manageable repayment terms: Repayment terms for personal loans often range from 12 to 60 months, and some lenders may allow you to extend your repayment period.
- Your retirement savings are untouched: With a personal loan, you won’t have to borrow against the balance of your 401(k) plan.
- Hard credit checks: Although prequalifying for a personal loan only necessitates a soft credit inquiry, going through with your application will require the lender to conduct a hard credit pull.
- Has various fees: Your lender may impose some fees like origination, prepayment and late fees, which can increase the overall cost of your loan.
- Restrictions on fund usage: Some lenders may prohibit you from using your loan to fund post-secondary education expenses or business investments.
Which Is Better: A 401(k) Loan or a Personal Loan?
Whether you choose to take out a 401(k) loan or a personal loan will depend on your unique financial situation. You may want to get a personal loan and let the money in your retirement account grow tax-free.
To determine which loan option is right for you, consider the following tips:
- Know your credit score: If you have a credit score between 670 and 850, you have a better chance of getting favorable terms on a personal loan. But a 401(k) loan may be ideal for your borrowing needs if you have poor credit.
- Determine the purpose of the loan: As much as possible, it’s best to leave your 401(k) alone. A personal loan may be the wiser option if you only need money to finance a major purchase or your dream vacation.
- Evaluate the importance of retirement savings: If you want to build a secure retirement and avoid putting that at risk, consider getting a personal loan instead of a 401(k) loan.
As always, weigh the pros and cons of each loan option to ensure you’re making a smart financial decision.
FAQs About 401(k) Loans and Personal Loans
MoneyGeek answers frequently asked questions about 401(k) loans and personal loans to help you decide which is best for your situation.
Learn More About Personal Loans
Personal Loans
sources
- Federal Reserve System. "Consumer Credit - G.19." Accessed January 16, 2023.
- Internal Revenue Service. "Considering a Loan From Your 401(k) Plan?." Accessed January 16, 2023.
- Internal Revenue Service. "Retirement Plans FAQs Regarding Loans." Accessed January 16, 2023.
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