401(k) Loan vs. Personal Loan: What’s the Better Option?

Life happens. And when you need extra cash, there are several loan options you can turn to. 401(k) loans and personal loans are two of the most popular options.

We’ll go over the basics of each loan option, their pros and cons and help you figure out when one might be a better choice than the other.

What Is a 401(k) Loan?

A 401(k) loan lets you borrow against your 401(k) account balance. But it’s not considered a loan in the traditional sense because you borrow money from your own retirement savings – not a lender. You can use the money for virtually anything, including debt consolidation, medical expenses or home improvements.

Here are the 401(k) loan basics you need to know:

• Amount: You can usually borrow up to $50,000 or 50% of your 401(k) account balance, whichever is less.^[1]
• Qualifications: You must also confirm that your retirement plan will let you borrow money. You don’t need a credit check to receive a 401(k) loan.
• Interest: Your retirement plan provider will determine the loan’s interest rate. Any interest charged on a 401(k) loan goes right back into your 401(k) savings account (unlike traditional loans where interest is the cost of borrowing).
• Repayment: With most plans, you can either deduct your loan payment from your take-home pay or make monthly payments. Typically, the loan repayment term for 401(k) loans is 5 years, but you may be able to pay off the loan early without worrying about prepayment penalty fees.

What Is a Personal Loan?

A personal loan allows you to borrow money from a lender and repay it over time on a fixed schedule. You can use personal loans for almost anything, like paying for unexpected expenses, your wedding, moving costs or paying off high-interest debt.

Personal loans can be unsecured or secured. Unsecured loans don’t require collateral to receive a loan but secured loans do. Because unsecured loans aren’t backed (or secured) by an asset, they typically have higher interest rates than secured loans. When you need a personal loan, more often than not, you’ll get an unsecured personal loan.

Here are the basics you need to know for personal loans:

• Amount: You can usually borrow around $2,000 – $45,000, though the exact amount will vary by lender.
• Qualifications: Your credit score and debt-to-income (DTI) ratio will be two of the most important factors your lender will review. They’ll also look for a stable employment history. The exact credit score you need for a personal loan will depend on your lender.
• Interest: Your creditworthiness will be a major factor in the interest rate a lender offers you. More often than not, you’ll receive a fixed interest rate, though some lenders offer personal loans with variable interest rates.
• Repayment: The loan repayment term can be anywhere from 1 – 7 years, although some lenders may offer longer loan terms. You’ll likely have a fixed monthly payment that includes principal and interest. And unlike 401(k) loans, you may be charged a prepayment penalty if you pay off your loan early.

401(k) Loan vs. Personal Loan: Which Is Better?

Getting a 401(k) loan isn’t necessarily better than getting a personal loan or vice versa – it all depends on your financial goals.

We’ve put a list of pros and cons together for each option to help you weigh which choice works best for your situation.

Now let’s take a look at personal loans.

401(k) Loan vs. Personal Loan: Which Is Right for You?

To figure out which loan is right for you, take an honest assessment of your financial situation and borrowing needs.

A personal loan may be the right choice if you have a good credit history, higher credit scores, a low DTI and a small 401(k) account balance.

If you have a poor credit history, bad credit scores, a higher DTI and a large 401(k) balance, a 401(k) loan may be the right for you.

A steady job and paycheck is an advantage for both loans. But remember, one downside of a 401(k) loan is if you lose or leave your job, you’ll need to repay the entire loan along with possible penalty fees – which doesn’t happen with a personal loan.

Work through the benefits and drawbacks of each loan before making a decision.

Final Thoughts on 401(k) Loans vs. Personal Loans

It’s clear that 401(k) loans come with many advantages: there is no credit check requirement, their interest rates are lower than personal loan rates and the loan’s interest payments get deposited into your retirement account. The disadvantage is that you withdraw money from your retirement savings – money that won’t benefit from the power of compounding earnings.

A personal loan may have a higher interest rate than a 401(k) loan, but it may be the savvier money decision because you’re not raiding your retirement savings.

Of course, you’ll need to weigh a personal loan’s higher interest rate, but remember that you may end up paying more in penalties with a 401(k) loan if you leave or lose your job before your loan is repaid.