Life happens. And sometimes, you don’t have the money you need in a bank account or a credit card to pay for life’s expenses. Getting a 401(k) loan or a personal loan can help cover those expenses quickly.
Personal loans and 401(k) loans are both short-term installment loans. They are fairly easy to apply for and are great options if you need to borrow a few thousand dollars. But some advantages may make one financing option better than the other.
We’ll go over the basics of each loan option, the pros and cons of each loan and help you figure out when one might be a better choice than the other. Knowing the ins and outs of these loans will help you make informed decisions about the best option for your needs.
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 retirement savings – not a lender. You can use the money for virtually anything, including debt consolidation, medical expenses or home improvements.
They are helpful when you need money in a pinch (usually a few days) and want to avoid the obscenely high interest rates that can come with other quick financing options, like payday loans or bad credit loans. Plus, you usually don’t pay taxes on what you borrow unless you violate your repayment terms. You may, however, have to pay a small fee to get the loan.
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. If you have less than $50,000 in your 401(k), you’ll only be able to borrow 50% of your account balance.
- Qualifications: You must also confirm that your retirement plan will let you borrow money. You can cross a credit check off the to-do list. 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 will 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.
Like 401(k) loans, personal loans can be a good option if you need quick financing – receiving money in as little as 24 hours. You may pay a small fee, usually an origination fee, to get the loan.
Here are the basics you need to know for personal loans:
- Amount: You can usually borrow up to $50,000, though some lenders offer loans for as much as $100,000.
- Qualifications: The size of the loan and the loan terms you receive will be based primarily on your creditworthiness and income. A credit score in the mid-600s or higher and a debt-to-income (DTI) ratio of 36% or lower will get you more favorable terms. Lender requirements do vary, so be sure to shop around for the best loan offers.
- 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.
There is no straightforward answer, but examining the benefits and drawbacks of 401(k) loans and personal loans can help you see how they stack up against each other.
The interest you pay on the loan is deposited right back into your 401(k) savings account. You’ll end up increasing the balance in your account (after paying off your loan), which will accrue investment earnings.
You may be able to snag a lower interest rate than you would on a personal loan.
Unlike personal loans, credit checks aren’t required to get a 401(k) loan, and the loan won’t show up on your credit reports, which means it won’t impact your credit scores. While we would never advise missing payments or making late payments, missed or late payments won’t affect your credit scores. (FYI: This is not the case with personal loans.)
You may be able to receive funding in as little as a few days.
Retirement savings accounts grow from the power of compounding earnings. No matter how much you decide to borrow, you’ll lose the money you would have earned on it if you had kept it in your account.
If you have less than $50,000 in your 401(k) account, you’ll only be able to borrow up to 50% of your account balance. So, depending on how much money you need, it may not be your best option.
The IRS can impose a 10% early withdrawal penalty on the amount you borrow if you’re under age 59½. If you can’t repay the loan on schedule or you leave or lose your job before you’ve finished repaying the loan, you may pay tax penalties and income taxes because the IRS will treat the loan like income instead of tax-exempt 401(k) money.
If you take out a 401(k) loan and lose your job or leave your company, you’ll still need to repay the loan. And you’ll usually repay it in a lump sum.
Now let’s take a look at personal loans.
With personal loans, you may be able to choose a repayment term that works best for you. But your repayment term may be assigned with a 401(k) loan.
Getting a personal loan means not having to pay an early withdrawal penalty if you’re under age 59½. If you decided to take a 401(k) loan, you’d likely have to pay an early withdrawal penalty before age 59½.
You may be able to receive funding in as little as 24 hours.
Because you’re not borrowing from your 401(k), your retirement savings are safe, and you’ll keep earning on your vested account balance (the amount in your retirement savings account).
Your loan will likely show up on your credit reports and impact your credit scores. Late or missed payments can hurt your credit scores.
Credit checks are required to get a personal loan. If your credit is poor, the amount you can borrow may be limited.
Personal loans usually have higher interest rates than 401(k) loans. And unlike a 401(k) loan, the interest you pay goes right into your lender’s pockets – not your retirement account. So you essentially lose money on your interest payments.
Lenders typically impose a penalty if you pay off your loan early. That usually isn’t the case with 401(k) 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.
Get Personal With Your Situation
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 withdrew 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.