Learn which type of financing works best for your specific needs.
How do personal loans differ from 401(k) loans?
You can get a personal loan from credit unions, banks and alternative sources like peer-to-peer (P2P) lenders. These loans can come in several forms: student loans, home loans, unsecured personal loans and auto loans are just a few. The APR, loan term and maximum amount you can borrow will differ from lender to lender.
When you take out a 401(k) loan, you’re borowing withdrawn from your retirement plan. Though you won’t pay any interest to the brokerage managing your loan, you’ll lose out on potential gains. These loans are typically capped at $50,000 or 50% of your account balance, whichever is less. These loans must be repaid within five years. If you’re older than 59.5 and you don’t pay for 90 days, the money is taxed as income and subject to a 10% penalty.
|Personal loan||401(k) loan|
|Interest rate||Varies among lenders, usually between 3.99% to 36%||None|
|Maximum loan amount||Up to $100,000, depending on the lender and your eligibility||$50,000 or 50% of your 401(k) balance, whichever is less|
|Repayment terms||Usually fixed, monthly repayments||Typically taken out of your paycheck; if you leave your place of employment, the entire amount becomes due within 60 days|
|Tax implications||None||A period of 90 days without a repayment results in the amount taxed as income, with a potential 10% penalty on top if you’re under 59.5 years old|
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What are the benefits of personal loans and 401(k) loans?
- No tax implications. You won’t be charged income tax on the amount you borrow unless the debt is forgiven by the lender, and even then you’ll find several exceptions.
- Borrow a significant amount. Depending on the lender and your qualifications, you may be able to borrow upward of $100,000.
- Repayment terms. You can repay your loan in one to seven years, depending on the lender.
- Negotiate repayments. If you have trouble making the payments, you may be able to negotiate your repayments.
- You don’t lose on interest. Any interest paid on the loan goes back into your retirement account.
- Repayments are easy. Repayments are automatically deducted from your pay, as long as you’re with the same employer.
- No credit check. Because you’re borrowing from yourself, you won’t undergo a credit check of any kind.
- Quick access to funds. Since there’s no credit check involved, you can sometimes borrow from your 401(k) in just a few clicks.
What are the drawbacks of personal loans and 401(k) loans?
- Good to excellent credit required. Higher dollar loans typically require a higher credit score. It’s not the only determining factor, but it significantly influences approval decisions.
- Interest rates. Interest is charged on the principal amount of the loan. Depending on the APR and loan term, you could end up paying thousands of dollars more than the original amount borrowed.
- Fees. Depending on the lender, you may face fees you weren’t expecting — such as origination fees or early repayment penalties. It’s important to read over the entirety of the loan agreement to avoid any surprises.
- Impact on credit score. If you fail to make payments or default on the loan, it can negatively affect your credit.
- You’re taking from your retirement. If you don’t repay your 401(k) loan, you’ll have less money for retirement.
- Loss of gains. Any gains that could have been made on the amount you withdraw are lost.
- Forced early repayment. If you’re laid off, quit or leave your employer, the full outstanding balance of the loan becomes due within 60 days.
- Potential taxation. If you fail to make payments for 90 days, the outstanding balance becomes a distribution and is taxed as income. Any penalties for early distribution apply at that time.
Is a 401(k) loan the same as cashing out my 401(k)?
In a word: No. Cashing out your 401(k) involves taking funds directly out of your retirement fund. A 401(k) loan is borrowing with specific terms and conditions outlined by the IRS. You’ll have to pay hefty fees to cash out your 401(k) if you access it before retirement — meaning that you won’t be left with much. You won’t have to pay these fees with a 401(k) loan as long as you repay it and stick with the same employer.
Which borrowing option is better suited for me?
If you have a good credit score and you’re looking to make a big purchase, consolidate debt, fund your education, get capital for your business or cover some other expense, a personal loan could be a good choice. A personal loan can be especially appropriate if you’re looking to borrow a significant amount and don’t have that much money in your 401(k) retirement account.
If you’re facing a financial emergency and your credit is less than perfect, a 401(k) loan may be your better option. Rather than going through a short term lender which can be costly, you can borrow from yourself and pay back any “interest” directly to your retirement account.
Consider these 3 alternatives
So you can’t qualify for a competitive rate on a personal loan, but a 401(k) loan is too risky. You might want to check out these other options:
- Consigner loans. Some personal loan providers allow you to apply with a creditworthy cosigner to help you meet eligibility requirements or get a more competitive rate.
- Secured personal loans. Backing your loan with collateral like a car, savings account or other high-value assets can help you qualify for more competitive rates and larger amounts than you would have on your own.
- Home equity loans and lines of credit. Also known as a second mortgage, this option uses what you own of your home as collateral. These are typically not difficult to qualify for and can come with competitive rates. Plus, any interest you pay is tax-deductible.
There are very specific situations where a 401(k) loan may be more beneficial than a personal loan, but it’s important to understand the risks. Personal loans come with less risk but could end up costing more over the life of the loan because lenders charge interest on top of the loan amount.
Whether you take out a 401(k) loan, a personal loan or another form of credit, be sure to read through the entire terms of the loan before you sign anything. It’s also important to be sure that you can afford the loan, as failing to repay can have serious consequences.
If you’re still unsure what’s best for your situation, compare your many loan options, speak with a financial professional or even talk with a trusted friend.
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