401(k) loan or personal loan: Which is right for you? (2024)

FAQs

401(k) loan or personal loan: Which is right for you? ›

If you plan to retire soon (in five years or less), a 401(k) loan may not be the best option—you must repay the loan within that period to avoid penalties. In that case, a personal loan may be the better way to go. In most circ*mstances, borrowing from a 401(k) should be a last resort.

Money withdrawn from your 401(k) account will not be earning interest, so your retirement savings might not grow at the same rate. Using a personal loan to consolidate debt may save you money in interest on higher-rate debts which could help you manage your budget effectively or add to your savings.

You're missing out on investment growth

When you reduce the balance of your 401(k) account, you have less money growing along with potential gains in the market. In addition, some 401(k) plans have terms that prevent you from being able to make further contributions until the loan is repaid.

Unlike other loans, 401(k) loans generally don't require a credit check and do not affect a borrower's credit scores. You'll typically be required to repay what you've borrowed, plus interest, within five years. Most 401(k) plans allow you to borrow up to 50% of your vested account balance, but no more than $50,000.

If you have a high-interest debt, such as from a credit card with a big balance, you may get a much lower interest rate on a 401(k) loan. If you have upcoming debt payments and no other alternatives for paying them, borrowing from your 401(k) can reduce fees and penalties.

The processing time for a 401(k) loan typically ranges between one to two weeks. However, this timeline is not fixed and can vary based on the specific procedures of your plan administrator and the completeness and accuracy of your application.

Deferring Social Security payments, rolling over old 401(k)s, setting up IRAs to avoid the mandatory 20% federal income tax, and keeping your capital gains taxes low are among the best strategies for reducing taxes on your 401(k) withdrawal.

401(k) loans

Remember, you'll have to pay that borrowed money back, plus interest, within 5 years of taking your loan, in most cases. Your plan's rules will also set a maximum number of loans you may have outstanding from your plan.

A plan may provide that if a loan is not repaid, your account balance is reduced, or offset, by the unpaid portion of the loan. The unpaid balance of the loan that reduces your account balance is the plan loan offset amount.

What two types of loan should you avoid? ›

You Could Boost Your Credit Score

Taking out a personal loan increases your credit mix, which makes up 10% of your score. It shows creditors and lenders that you're responsible with money by carrying many different types of credit and debt. You'll also lower your credit utilization by paying down your debt.

Subsidized loans don't generally start accruing (accumulating) interest until you leave school (or drop below half-time enrollment), so accept a subsidized loan before an unsubsidized loan. Next, accept an unsubsidized loan before a PLUS loan.

Risks of taking out a 401(k) loan

“If you leave your job, or are no longer employed with that company, you will be forced to pay the full balance of the loan back, and if you can't do that, whatever you can't pay back, you'll be subject to the taxes because it will count as an early distribution plus a 10% penalty.”

You may face a denial: If you are nearing retirement, you may be deemed a higher risk and thus denied a loan because payments will no longer automatically come out of your paycheck.

As much as you may need the money now, by taking a distribution or borrowing from your retirement funds, you're interrupting the potential for the funds in your 401(k) plan account to grow through tax-deferred compounding — and that could make it more difficult for you to reach your retirement goals, says Feist.

Reasons to borrow from your 401(k) include speed and convenience, repayment flexibility, cost advantage, and potential benefits to your retirement savings in a down market.

If your plan permits loans, you can typically borrow $10,000 or 50% of your vested account balance, whichever is greater, but not more than $50,000. For example, if you have $150,000 vested in your 401(k) account, then you wouldn't be able to borrow the full 50%, or $75,000, of your vested balance.

Once you reach 59½, you can take distributions from your 401(k) plan without being subject to the 10% penalty. However, that doesn't mean there are no consequences. All withdrawals from your 401(k), even those taken after age 59½, are subject to ordinary income taxes.

While it's possible to fund a down payment from a 401(k), it's generally not recommended.