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401(k) loans explained
Are these easy, low-interest loans really worth the risk?
Updated . What changed?
401(k) loans may be worth the potential hit to your retirement account if you’re able to pay it off quickly, continue regular contributions and stick with your employer. If not, you’re probably better off considering other loan options.
What is a 401(k) loan?
A 401(k) loan is money that you borrow from your company-sponsored retirement account. Like other loans, you’ll pay back principal plus interest. But your credit score doesn’t matter, and you won’t have to fill out an application. Interest rates are also lower, making it a less expensive option than other secured loans.
However, it’s not usually an ideal option. Borrowing from your 401(k) can get expensive if you switch jobs or have trouble making repayments. Because most people don’t have enough in their retirement savings to begin with, a 401(k) loan may also make retiring more difficult down the road.
401(k) loan snapshot
|What it is||A loan taken from your 401(k) retirement account that you repay with interest over five years.|
|Who it’s best for||People who are on top of their finances and have airtight job security.|
|Who should look for other financing||People struggling with debt or thinking of leaving their job soon.|
How do 401(k) loans work?
401(k) loans are regulated by the IRS, but your loan terms are ultimately determined by your employer. Once you know the term and APR, you can calculate how much your 401(k) loan will cost.
Most 401(k) plans won’t allow you to borrow more than $50,000 or 50% of your account balance, whichever is less. If your account balance is lower than $20,000, you could borrow up to $10,000 but you’ll likely have to provide collateral.
Here’s how it typically breaks down:
|Account balance||How much you can borrow|
|$15,000||$10,000 with collateral|
Some employers also set minimums on how much you can borrow — usually $1,000.
Coronavirus stimulus package increases 401(k) borrowing limits
In an effort to provide financial assistance to Americans impacted by the COVID-19 outbreak, the federal government passed the Coronavirus Aid, Relief and Economic Security (CARES) Act. The bill increases how much you can borrow from your 401(k) — from $50,000 up to $100,000. Due dates for any new loans you take out are also extended for one year.
To qualify for this increased amount, you need to prove that your finances — or those of your spouse or dependent — were negatively affected by the coronavirus outbreak. And you’re only eligible to borrow this higher amount until September 23, 2020.
The interest rate on most 401(k) loans is the prime rate plus 1%, though your exact rate depends on your employer. The prime rate is what many financial institutions give to only the most creditworthy applicants, typically hovering around 3% or 4%.
All interest you pay goes back into your 401(k) account. But returns are usually higher than the interest you’re paying, so it doesn’t make up for losses.
Most 401(k) loans come with five-year repayment plans. An exception is mortgages: The IRS doesn’t specify how long your mortgage can extend, so your repayment term again depends on your employer.
Watch out: Your employer can restrict how you use your 401(k) loan
The IRS allows employers to limit the reasons that an employee can use to borrow against their 401(k).
If your employer does, it’s not uncommon to them limit your loan for use toward:
- Education expenses for yourself, a spouse or a child
- Medical expenses
- Housing expenses, including mortgages and eviction prevention
Be sure to check with your employer first before borrowing against your 401(k).
Taking out a 401(k) loan is not as complicated as with other loans. Start by setting up a meeting with your HR department to discuss your options. During your meeting, make sure to:
- Discuss the reason you want the loan, and confirm that reason isn’t restricted by your employer
- Review your 401(k) account and figure out how much you can borrow
- Learn what your interest rate will be
- Request early or extended repayments if a five-year loan term doesn’t make sense for the amount you’re borrowing
- Ask about repayments, which are typically deducted from your paycheck after taxes
Your employer might ask you to complete forms before receiving your funds, but it’s nothing as extensive as a typical loan application.
How long does it take to get a 401(k) loan?
It usually takes at least one week for your 401(k) loan to be disbursed. But in some cases it can take two weeks or longer. Like most aspects of a 401(k) loan, it depends on how quickly your employer can process your request.
Why you might not want to borrow from your 401(k)
401(k) loans aren’t as expensive as other personal loans, but there are a few reasons it shouldn’t be your first choice:
You have to repay it quickly if you lose your job
Your 401(k) is connected to your employer, so if you get laid off — or just decide to get a new job — you have two to three months to pay back your entire loan before you default.
If you default, your loan is considered an early withdrawal from your 401(k). Early withdrawals come with taxes and penalties that can add up to 25% of your balance.
You lose protection from bankruptcy
Funds in your 401(k) are protected from bankruptcy as long as they’re still in the account. But once they’re borrowed in the form of a loan, your funds are no longer protected. If you end up filing for bankruptcy, the court may seize it to pay off your creditors.
You’ll pay double taxes on a portion of your 401(k)
401(k) funds are tax-deferred, meaning you don’t pay taxes on the money you put into it until you withdraw it for retirement.
This changes if you take out a 401(k) loan. When repaying the loan, your employer deducts taxes first before withdrawing your repayment from your paycheck. And you still have to pay taxes later. This can still be less expensive than other financing options though, so make sure you compare all costs.
You lose out on investment returns
You gain interest on the money you put into your 401(k). The less money you have in your 401(k) balance, the less you’ll get in returns. Even if you do repay your 401(k) loan on time, you won’t have gained as much from interest as you would have if you left your account alone.
But the amount lost can be lessened by paying it back quickly. If you need the loan for a relatively short term, you may not be left in a bad spot.
You’ll likely contribute less — or not at all
While you can still contribute to your 401(k) while you’re repaying the loan, you might not have the funds to do so. This can cost you thousands in retirement savings if you don’t repay the loan quickly. And reducing your contributions to your 401(k) can be a costly move for your future.
When a 401(k) loan might make sense
Finding out if a 401(k) loan is right for you means comparing it against other types of financing. And aside from making sure it can be used for the expense you need to cover, that means understanding how much it could cost you — in terms of taxes, potential penalties and losses.
Once you figure out how much your 401(k) loan could cost, compare that cost against other ways you can finance your expense. Personal loans, other investments, borrowing from friends or family and other alternatives might end up being a less expensive solution.
How to make the most of a 401(k) loan
Borrowing against your 401(k) might make sense if you know you can repay your loan quickly, want to take advantage of a low APR or have exhausted your other borrowing options.
Here’s how to make sure you don’t regret taking out the loan:
- Continue regular contributions to your 401(k). You’ll lose substantially less from your 401(k) if you continue making your regular contributions each pay period.
- Stay with your employer. While you can’t always control being fired, you can control if and when you decide to quit. Avoid taking any new positions that could affect your 401(k) until your loan is fully repaid.
- Borrow the minimum amount. Figure out how much you need to borrow and only take out that exact amount to avoid unnecessary losses on returns.
- Take the shortest amount of time to pay it off. Along with borrowing the least amount that you need, this can help you get back on track for your retirement savings goal as quickly as possible.
Alternatives to 401(k) loans
You might want to rule out the following options before taking out a 401(k) loan:
- Personal loans. Personal loans allow you to borrow anywhere from $1,000 to $100,000 — depending on your credit and if you choose to provide collateral. There are a few major differences between personal loans and 401(k) loans, so consider the pros and cons of both before making a final decision.
- Thrift Savings Plan loans. If you are a federal government employee or a uniformed service member, you can borrow against your Thrift Savings Plan. However, has many of the same drawbacks as a 401(k) loan.
- Other investments. If you have other investments, consider cashing those in first — you won’t have to pay as many taxes and penalties as with a 401(k) loan.
- Friends and family. Your loved ones may be able to help if you’re tight on cash and don’t have other options. Just be aware that it can seriously damage your personal relationships if you’re unable to pay it back.
- Crowdfunding. Set up a campaign on a crowdfunding platform and ask friends, family and members of your social network to make small donations toward covering your expenses.
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The low interest rate and easy application process might make 401(k) loans sound like an attractive option. But even those with absolute job stability and impeccable personal finances aren’t completely safe from risk. Take caution when considering this borrowing option — and read our guide to personal loans to learn more about your other loan options.
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