If you borrow from your 401k account, your employer’s retirement account plan documents will determine how much interest you’ll pay on the loan. Adding 1% to the prime rate is a common approach to setting this rate. It usually will be lower than the interest charged on a personal loan, credit card cash advance or similar source. And, when you pay back interest and principal, it goes into your retirement account instead of to a lender. Still, 401(k) loans can involve noteworthy limits and risks. A financial advisor can help you decide whether a 401(k) loan makes sense for you.
401(k) Loan Interest Basics
If you contribute to a 401(k) retirement plan at your employer, you may be able to take out a loan from the assets in your account. These loans often offer advantages over other financing methods. The main one is that any interest you pay back goes into your retirement account instead of to a bank or other lender.
The amount of interest you pay will also likely be less than you’d pay if you took out a personal loan or obtained funds using nearly another financing method. The plan documents governing your employer’s retirement offering will lay out how the interest rate will be determined.
In most cases, this rate will be based on the prime interest rate. You’ll likely find that the rate you pay will be the prime interest rate plus 1%. So, if the prime rate were 8%, in this case, you’d pay 9% interest on your loan.
Using a 401(k) Loan
Thanks in part to the usually competitive interest rate, a 401(k) loan can make financial sense. For example, say you have $10,000 in credit card debt at a 25% interest rate. You’ve been trying to get it paid off but the high interest charges are making it difficult.
Your employer’s retirement plan is one of those that do allow 401(k) loans, so you borrow $10,000 from your account and pay off the credit card balance. You still owe the $10,000, but now you owe it to yourself or, technically, your retirement plan. You opt to take the full allowed five years to pay back the loan at 9%.
Your monthly payment will be $208 and the total amount of interest you pay will come to $2,455. If you’d stuck with paying off the credit card balance at 25%, you might still have been able to pay it in five years. But you would have paid $7,611 in interest and your monthly payment would have been $294, reducing your cash available for other purposes.
In this example, using a 401(k) loan will save you $5,156 in interest. Plus, as noted, you’re actually paying the interest to yourself rather than the lender that provided the funds.
Other 401(k) Loan Considerations
Some 401(k) plans don’t allow loans, so this option may not be available at all. Even if it is, it’s not always a good idea to borrow from a 401(k). But in the right situation, the strategy has significant advantages compared to the alternatives.
Getting back the interest you pay isn’t the only benefit. You don’t have to qualify for a 401(k) loan based on your credit score, income or other loan underwriting criteria. If you want to do it and the plan allows it, you can take out the loan. Plus, there’s no credit check to potentially impact your credit score. The 401(k) loan won’t even show up as a loan on your credit history.
Consider some of the risks and limits as well, however. For one, you can borrow no more than half the vested amount in your plan or $50,000, whichever is less. If you need more you’ll have to go elsewhere. Also, while plan rules vary, often you’ll have to pay it back in five years in equal payments. Again, if you need more flexibility, the plan may not be able to accommodate you.
Another potential problem is that if you lose your job at the employer sponsoring the plan, you may have to pay the loan back in a short period, often 60 days. If you don’t meet the new payback deadline, you may be required to treat the loan as an early withdrawal subject to taxes and a 10% penalty.
Another possible drawback is that the money you take out of the plan is not invested while you’re paying it back, so you could miss out on growth. Of course, if the market declines broadly while your loan is out this could be a benefit.
A final downside is that the interest you pay back could be subject to double taxation. That is, you will pay the interest using taxed dollars. Then, when you withdraw the funds later on, you’ll have to pay taxes on those withdrawals, including the already-taxed interest you paid in earlier.
Bottom Line
A 401(k) loan is likely to offer a lower interest rate than you could get elsewhere. Typically, this might be the prime rate plus 1%. The interest you pay on the loan goes back to you rather than to a lender. The combination can make a 401(k) loan an attractive option. However, it’s important to consider the potential downsides.
Tips for Personal Finance
- A financial advisor can look at your full financial picture and identify strategies for approaching borrowing, saving, investing and more. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- SmartAsset’s Personal Loan Calculator can tell you how much you’ll pay in interest and the size of monthly payments when you take out a loan.
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