Which One Is Right for You?

401(k) Loans vs. Personal Loans

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Updated: May 17, 2024

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When you need quick access to funds, 401(k) loans and personal loans are two options worth considering. While a 401(k) loan allows you to borrow against your retirement savings, a personal loan lets you borrow from a lender based on your creditworthiness.

Understanding the differences between a 401(k) loan and a personal loan will help you determine the best option for your unique situation. Each type of loan carries unique advantages and drawbacks, affecting your immediate financial needs and long-term financial health.

Key Takeaways

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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.

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A personal loan usually doesn’t require collateral and can be used to consolidate debt, finance a major purchase or fund home improvement projects.

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Deciding between a 401(k) loan or a personal loan depends on your specific needs. It’s wise to weigh each option’s benefits and drawbacks before choosing.

What Is a 401(k) Loan?

A 401(k) loan is a way to borrow money from your retirement savings. Essentially, you're taking a loan against the balance in your 401(k) account. This option allows you to access funds without a traditional loan application, as it doesn't require a credit check. The process involves borrowing against the amount you've accumulated in your 401(k) and then repaying this amount, plus interest, through paycheck deductions using your after-tax earnings.

Plans also have discretion over features like loan amounts, terms, rates and eligibility. The specifics can vary depending on your plan's rules, so checking with your plan provider for the exact terms is important. With a 401(k) loan, you can use the borrowed funds for various purposes, such as home repairs, medical expenses or even debt consolidation.

Features of 401(k) Loans

Generally, a 401(k) loan allows you to borrow up to $50,000 or 50% of your vested account balance, whichever is less, with a repayment period typically up to five years.

GENERAL REQUIREMENTS

To be eligible for a 401(k) loan, you must participate in your employer's 401(k) plan with a sufficient vested balance. The plan itself must allow loans, as not all do, and specific requirements can vary by employer. Borrowers often choose this option because it doesn't require a credit check, making it accessible for many.

INTEREST RATES

The interest rate on a 401(k) loan is typically one or two points above the prime rate. It's paid back into your 401(k) account, meaning you are paying the interest to yourself. However, it's important to note that while the rates are typically lower, they are still a cost to consider.

REPAYMENT TERMS

Repayment of a 401(k) loan is usually done through payroll deductions, spread evenly over the loan term, which is generally up to five years. There may be options for early repayment without penalty. If you leave your job, whether by choice or not, the outstanding balance typically becomes due sooner, often within a few months, or will be treated as a taxable distribution. When used specifically to acquire a primary residence, such as purchasing or building a home, some 401(k) plans allow for an extended repayment period beyond the standard five years, often up to ten years.

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EXPERT TIP

When an employee leaves a job, whether voluntarily or involuntarily, there is typically a grace period during which the outstanding balance of the 401(k) loan must be repaid to avoid taxes and penalties. This grace period is usually around 60–90 days but can vary depending on the employer's plan rules. During this period, the employee may be able to repay the loan in full or set up a repayment plan to avoid default. If eligible, a loan may be rolled over to a new employer's 401(k) to continue paying per the original terms. — Alvin Yam, CFP®

Advantages and Disadvantages of 401(k) Loans

A 401(k) loan can be an appealing option due to its straightforward access and potential cost savings. However, it's helpful to weigh these benefits against the possible drawbacks, such as the impact on your retirement savings and limited availability. By carefully evaluating both sides, you can make an informed decision that aligns with your financial goals and current situation.

Pros of 401(k) Loans

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    No Credit Checks

    One of the key advantages of a 401(k) loan is that it doesn’t require a credit check. This makes it a viable option for individuals with less-than-ideal credit scores or a limited credit history. As a result, accessing funds can be quicker and easier than traditional loans, where creditworthiness is a significant factor.

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    Lower Interest Rate

    Typically, the interest rate on a 401(k) loan is lower than those on other types of loans. This lower rate can make a 401(k) loan a more affordable option, especially for those looking to consolidate high-interest debt. Additionally, the interest paid goes back into your 401(k) account, which can partially offset the cost of borrowing.

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    Avoid Taxes and Penalties

    When you borrow from your 401(k), you're not taking a distribution, so the loan is not subject to taxes or early withdrawal penalties. This is a significant benefit over withdrawing funds from your 401(k) before retirement age, which can lead to hefty penalties and a substantial tax bill. A 401(k) loan allows you to access your funds without these financial setbacks, provided the loan is repaid according to the terms.

Cons of 401(k) Loans

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    Low Borrowing Limits

    The amount you can borrow from your 401(k) is capped at $50,000 or 50% of your vested account balance, whichever is less. This limit can be restrictive for those who need larger sums of money for more substantial expenses, like major home renovations or debt consolidation.

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    Missing Out on Potential Growth

    When you take a loan from your 401(k), the borrowed money is no longer invested in the market. This means you potentially miss out on investment returns that could have been earned during the loan period. Over time, this can significantly impact the growth of your retirement savings, especially if the market performs well during the loan period.

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    Limited Availability

    Not all 401(k) plans offer the option of taking out a loan. Availability depends on your employer’s plan specifics, and even if loans are offered, there might be restrictions on how and when you can borrow. This limitation means that some employees may not have access to this borrowing option, making it less reliable as a universal financial solution.

What Is a Personal Loan?

A personal loan is often unsecured, meaning it doesn't require collateral like a home or car. It works by allowing you to borrow a lump sum of money, which you then repay with interest in monthly installments over a set period. Depending on the loan terms, this period can range from a few months to several years.

The maximum amount you can borrow with a personal loan varies considerably based on the lender and your financial circumstances, including your income and credit score. Personal loan amounts that can be borrowed vary between lenders, from minimums as low as $600 to average maximums of $50,000 or less. Some of the most competitive lenders may offer higher maximum amounts of up to $100,000 based on an applicant's annual income, credit score and repayment history. Maximum amounts also depend on the lender's unique policies.

Unlike specific loans like auto loans or mortgages, you can use a personal loan for almost any purpose. This could include home renovations, medical bills, wedding expenses or even a vacation. However, it's important to remember that, as with any loan, the responsibility to repay the amount borrowed with interest remains, so be sure to consider your ability to repay before taking out a personal loan.

Features of Personal Loans

A personal loan is an installment loan that allows you to borrow funds and repay them over an agreed-upon period with interest.

GENERAL QUALIFICATIONS

To qualify for a personal loan, lenders primarily assess your creditworthiness, which is reflected in your credit score. Other factors include your income, employment history and debt-to-income ratio. The stronger your financial profile, the more favorable the loan terms you will likely receive, including lower interest rates and larger loan amounts.

INTEREST RATES

The interest rate on a personal loan can vary significantly based on your credit score and the lender. Generally, higher credit scores result in lower interest rates. Unlike secured loans, which have collateral that can reduce a lender's risk, unsecured personal loans usually have higher interest rates to offset the increased risk to the lender. Some lenders offer lower interest rates for shorter-term loans.

REPAYMENT TERMS

Personal loans offer fixed repayment terms, where you pay a consistent amount each month until the loan is fully paid off. This term can range between two to seven years, impacting both the monthly payment amount and the total interest paid over the life of the loan. The flexibility in the repayment terms allows for managing the balance between affordable monthly payments and overall interest costs.

Advantages and Disadvantages of Personal Loans

Personal loans offer a flexible and accessible means of borrowing, making them a popular choice for various financial scenarios. However, it’s important to consider both the advantages and disadvantages. By carefully weighing these, you can decide if a personal loan is the most suitable option for your specific situation.

Pros of Personal Loans

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    High Borrowing Limits

    Personal loans often come with high borrowing limits, allowing individuals to access up to $100,000, depending on the lender. This makes them suitable for a range of financial needs, from debt consolidation to significant purchases or home renovations.

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    No Collateral

    One of the main advantages of a personal loan is that it is typically unsecured, meaning it does not require any collateral. This lack of collateral is beneficial for borrowers who do not wish to risk their assets, such as a car or home. It also simplifies the borrowing process, as there's no need to evaluate and approve collateral, making the loan accessible to a wider range of individuals.

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    Manageable Repayment Terms

    Most personal loans offer structured and manageable repayment terms, with fixed monthly payments over a predetermined period. This clear structure allows borrowers to plan their finances effectively, as they know the exact amount they need to repay each month. Additionally, the variety of term lengths, from short-term options to longer terms, gives borrowers the flexibility to choose a repayment schedule that aligns with their financial capacity and goals.

Cons of Personal Loans

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    Hard Credit Checks

    When applying for a personal loan, lenders typically perform a hard credit check to assess your creditworthiness. This check can temporarily lower your credit score and leave a mark on your credit report. If multiple lenders conduct these checks over a short period, it can significantly impact your credit score, making it harder to qualify for other forms of credit.

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    Fees

    Personal loans often come with various fees, such as origination fees, late fees or prepayment penalties. These can add to the overall cost of the loan, making it more expensive than initially anticipated. Borrowers should understand and factor in these additional costs when calculating the total expense of the loan.

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    Restrictions on Fund Usage

    While personal loans are versatile, some lenders may restrict how you can use the funds. For instance, some loans prohibit using funds for business purposes, investments or post-secondary education. These restrictions can limit the utility of the loan for certain borrowers, making it less suitable for those with specific financial needs or goals.

Comparing 401(k) Loans vs. Personal Loans

Both 401(k) loans and personal loans provide a way to access funds for various purposes, from handling emergencies to funding significant expenses. However, understanding their differences will assist you in determining which loan option is the best fit for your unique financial situation.

401(k) Loans
Personal Loans

Interest Rate

Interest rate is often one or two points above the prime rate.

Interest rate varies widely based on credit score and lender terms.

Loan Amount

Up to $50,000 or 50% of vested balance.

Can vary widely, often up to $100,000, depending on lender and creditworthiness.

Repayment Terms

Typically up to five years. If used for home purchase, it might be longer.

Generally between two to seven years, based on lender and loan amount.

Credit Impact

Because there’s no credit check required, it doesn’t impact your credit score directly.

Requires a credit check, which can potentially affect your credit score both positively and negatively.

Uses

Flexible, but must be repaid if employment ends.

Flexible, but some lenders may impose restrictions.

How to Choose Between 401(k) Loans and Personal Loans

Deciding whether to take out a 401(k) loan or a personal loan depends heavily on your specific financial situation. Before choosing, consider following these tips to guide you toward the most suitable option for your needs.

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    Know Your Credit Score

    Your credit score is critical in determining your eligibility and the terms you'll get with a personal loan. A high credit score can secure lower interest rates, making a personal loan more attractive. In contrast, a 401(k) loan might be preferable if you have a lower credit score, as it does not require a credit check.

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    Determine the Loan’s Purpose

    The reason for the loan can influence your choice. For instance, if you need funds for a short-term or small expense, a 401(k) loan might suffice. However, a personal loan could be more appropriate for larger, long-term financial commitments due to its higher borrowing limits and longer repayment terms.

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    Calculate the Amount You Need

    Assess how much you actually need to borrow. If your requirement exceeds the borrowing limit of a 401(k) loan, a personal loan might be your only option. Conversely, a 401(k) loan could be more convenient and cost-effective for smaller amounts.

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    Evaluate the Importance of Retirement Savings

    Consider how taking out a 401(k) loan might impact your retirement savings. Borrowing from your 401(k) can reduce the growth potential of your retirement funds due to missed investment opportunities. If maintaining the growth trajectory of your retirement savings is a priority, you might lean toward a personal loan to avoid disrupting your long-term financial security.

FAQ About 401(k) Loans vs. Personal Loans

MoneyGeek answered some frequently asked questions about 401(k) loans and personal loans to help you decide which is best for your situation.

Does a 401(k) loan affect your credit?
Can I get a loan from my 401(k) to pay off my debt?
Does a 401(k) loan count as income?
How much will I be taxed on a 401(k) loan?
Is it worth getting a personal loan to pay off debt?
Does it hurt to pay off a personal loan early?
How much does your credit score drop when you get a personal loan?
Which type of personal loan is easiest to get?
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The content on this page is accurate as of the posting/last updated date; however, some of the rates mentioned may have changed. We recommend visiting the lender's website for the most up-to-date information available.

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