When you take a 401(k) loan, you are tapping into the retirement savings you have been setting aside for retirement. A 401(k) loan is different from a traditional loan since you are borrowing your own money. Also, the 401(k) loan interest you pay goes back to the 401(k) account.
The interest rate on a 401(k) loan is based on the prime rate, and it adds one or two points above the prime rate. The prime rate is determined by individual banks, using the federal funds rate as a benchmark. The loan interest goes back to your 401(k) account to help replenish the account balance. Typically, the 401(k) loan interest is usually lower than the interest you pay on other types of loans such as personal loans and credit card loans.
What 401(k) interest rate do you pay on a 401(k) loan?
401(k) loan interest is based on the prime rate. This is the rate that commercial lenders use to provide credit to their most creditworthy creditors. When determining the 401(k) loan interest rate, 401(k) plans add one or two points higher than the prime rate.
For example, if the prime rate sits at 4.5%, the 401(k) plan will set the 401(k) loan interest rate at between 5.5% and 6.5%. The interest rate will be the same for every participant who borrows a 401(k) loan, regardless of their credit rating.
The prime rate also forms the basis of other interest rates such as interest rates for mortgages and personal loans. However, the interest rate charged on a 401(k) loan may be lower than the rate you could get with a personal loan.
What is the Prime Rate?
The prime rate is the index that commercial banks use to set interest rates for creditworthy corporate clients. It uses the federal funds rate as its benchmark.
The Federal Reserve does not set the prime rate, but it is instead set by individual banks. Banks use the federal funds rate as the starting point for setting the prime rate for loans. Generally, the prime rate is usually about 3% above the federal funds rate.
Usually, the loan interest rate provides a way for lenders to cover the costs associated with lending. The interest compensates the lender for assuming the risk of extending credit based on the borrower's credit history. The interest rate is usually a few points above the prime rate, and this forms the underlying base for calculating interest rates. If the federal funds rate changes, this change is reflected in the prime rate, and subsequently, on the interest rate charged on 401(k) loans.
Where does 401(k) interest go?
The good thing with 401(k) loan interest is that you pay the interest back to your 401(k) account. This helps replenish the money you took from your 401(k) when taking the loan.
A drawback with the 401(k) loan interest is that you pay the money using after-tax dollars, which means that you are paying taxes on the money before putting the money in your 401(k) account. You will also owe taxes when you withdraw funds in retirement. Therefore, you will pay taxes twice on the loan interest you pay.
Does your credit score affect your 401(k) interest rate?
Your credit score does not determine the interest rate you pay on a 401(k) loan. Typically, your credit score does not affect your chances of getting approved for a loan, and you may be allowed to borrow from your 401(k) even with bad credit. Once the plan administrator sets the interest rate for 401(k) loans, this rate remains the same for all participants regardless of their credit scores.
Should You Get a 401(k) Loan?
Before taking a 401(k) loan, you should consider whether a 401(k) loan makes sense for your situation. Generally, if you have poor credit, a 401(k) can save you from high-interest debts.
A 401(k) loan charges a lower interest rate than other types of loans such as personal loans and credit cards, and you can expect to pay one to two percentage points above the prime rate. However, personal loans and credit cards can charge as high as 20% or more if you have an average credit score. Hence, you will be saving money when you borrow from 401(k) instead of taking a high-interest loan.
Before taking a 401(k) loan, you should consider the cost advantage of the 401(k) loan. You should compare the lost investment earnings against the interest you will pay back to the 401(k). The cost advantage is determined by taking the loan interest less any lost investment gains. If the cost advantage is negative, a 401(k) loan may be less desirable. However, if the cost advantage is positive, it means a 401(k) loan can be an attractive option since the loan interest exceeds the investment earnings.
What is the interest rate on a 401k loan? Retirement plans typically charge the current prime rate plus 1% to 2% interest rate on 401(k) loans. Since the interest rate on your 401(k) loan goes back into your 401(k) plan, it's similar to paying yourself back, but with post-tax funds.
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.
Many retirement planners suggest the typical 401(k) portfolio generates an average annual return of 5% to 8% based on market conditions. But your 401(k) return depends on different factors like your contributions, investment selection and fees. Sometimes broader trends can overwhelm these factors.
Any interest charged on the outstanding loan balance is repaid by the participant into the participant's own 401(k) account, so technically, this also is a transfer from one of your pockets to another, not a borrowing expense or loss.
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.
Here's how it works. The amount of money you borrow is never taxed twice…but the interest you pay on the loan is. That's because tax law requires you to pay yourself interest with after-tax money.
“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 be able to qualify for a lower interest rate than you could with a credit card or personal loan. You're paying interest back to yourself, rather than to a bank or lender. There's no credit check required and a 401(k) loan won't show up on your credit report.
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.
No credit reporting: A credit check isn't required when applying since there is no underwriting, and your 401(k) loan won't appear as debt on your credit report. You also won't damage your credit score if you miss a payment or default on your loan.
Many plans require a 6% deferral to get the full match, and many savers stop there. That may be enough for those who expect to have other resources. For most people, though, it probably won't be. If you start early enough, given the time your money has to grow.
When you apply for your loan, you'll also have to agree to terms of repayment. Most employees set up automatic payroll deductions to repay their loans and pause contributions until the loan is repaid.
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.
Among the pros of a 401(k) withdrawal is that you won't have to repay those funds. Taking money from your 401(k) can make sense when paying off high-interest debt, like credit cards, Tayne said. On the downside, your retirement savings balance will drop.
Some of the reasons why you can't borrow from your 401(k) include lack of spousal consent, you are nearing retirement, you have exhausted your 401(k) loan limit, you are no longer working for the employer, or if your job position is at risk due to ongoing restructuring.
The IRS dictates you can withdraw funds from your 401(k) account without penalty only after you reach age 59½, become permanently disabled, or are otherwise unable to work.
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