Explore your mortgage options
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.
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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.
- 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.
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. Also, the loan won’t show up on your credit reports, which means it won’t impact your credit scores.
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 have flexibility regarding the repayment terms you choose. Generally, the shorter your loan terms, the higher your monthly payment but the more you’ll save on interest.
You don’t have to pay a withdrawal penalty on funds you borrow with a personal loan regardless of your age.
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.
Personal loans usually max out around $45,000, although there are some exceptions.
The interest you pay on a personal loan goes to your lender rather than back into your own retirement account. Additionally, the interest rates on personal loans are generally higher than with 401(k) loans.
Depending on your loan terms, there may be 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.
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.
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The Short Version
- Getting a 401(k) loan isn’t necessarily better than getting a personal loan or vice versa – it all depends on your financial goals
- 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
- 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
IRS. “Retirement Topics – Plan Loans.” Retrieved January 2024 from https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-loans
IRS. “Hardships, Early Withdrawals and Loans.” Retrieved January 2024 from https://www.irs.gov/retirement-plans/hardships-early-withdrawals-and-loans