Interested in a loan but not sure which is your best choice? Learn which financing option is better for you.
How do personal loans differ from 401(k) loans?
When you’re considering taking out a loan, your first step should be to understand the differences between these two types of credit.
Personal loans are usually unsecured and offer funding between $5,000 to $50,000. Credit unions, banks and nontraditional sources like peer-to-peer (P2P) lenders all generally have a personal loan option that you can use to finance just about anything, from debt consolidation to a home renovation. Your APR and loan terms will depend on your lender, but you can generally expect your APR to be capped at 36% and terms lasting one to seven years.
When you take out a 401(k) loan, you’re borrowing withdrawn from your retirement plan.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, and must be repaid within five years. But much like a personal loan, the funds can be used to cover just about any expense, which makes them useful if you have a large amount in your retirement account and know you’ll be with your current employer for years to come.
|Personal loan||401(k) loan|
|Interest rate||Varies, but usually between 3.99% to 36%||Varies, but as low as Prime Rate + 1%|
|Maximum loan amount||Up to $100,000||$50,000 or 50% of your 401(k) balance, whichever is less|
|Repayment terms||Usually fixed, monthly repayments||Typically taken out of your paycheck|
|Tax implications||None||A period of 90 days without a repayment results in the amount taxed as income, with a potential 10% penalty 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.
- Borrow a large amount. Depending on the lender and your qualifications, you may be able to borrow as much as $100,000.
- Flexible payments. If you’re have trouble making payments toward your loan, you may be willing to negotiate your repayment schedule.
- You don’t lose on interest. Any interest paid on a 401(k) loan goes back into your retirement account.
- Payments are easy. Payments are automatically deducted from your paycheck as long as you remain with the same employer.
- No credit check. Because you’re borrowing from yourself, you won’t undergo a credit check. This also means you may be able to get your funds faster.
What are the drawbacks of personal loans and 401(k) loans?
- Good to excellent credit required. If you want to borrow a large amount, you’ll likely need to have nearly perfect credit to qualify.
- Interest rates. Depending on the APR and loan term, you could end up paying thousands of dollars more than the original amount borrowed.
- Fees. You may have to pay origination fees or an early repayment penalty. Read your loan agreement to avoid any surprises.
- You’re taking from your retirement. If you don’t repay your 401(k) loan, you’ll have less money for retirement.
- 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.
Which borrowing option is better suited for me?
Both personal loans and 401(k) loans provide borrowers with capital to cover large expenses, but the better choice for your situation isn’t necessarily obvious.
Personal loans are best if you have a good credit score and you’re looking to make a big purchase, consolidate debt, get capital for your business or cover another large expense. They’re especially handy if you don’t have a 401(k) or don’t want to dig into your retirement funds. And if you have good to excellent credit, you may be eligible for large loan amounts at low interest rates that won’t take a chunk out of your budget.
401(k) loans are best if you’re facing a financial emergency and your credit isn’t in the good to excellent range. Rather than going through a long application and credit check, you can borrow from yourself and pay back any “interest” directly to your retirement account. However, you’ll want to be sure you have job security. Otherwise, you may end up paying the whole loan amount back at once.
Is a 401(k) loan the same as cashing out my 401(k)?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 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.
Consider these 3 alternatives
If 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:
- Cosigner loans. Some personal loan providers allow you to apply with a 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 asset can help you qualify for more competitive rates and larger amounts than with an unsecured loan.
- Home equity loans and lines of credit. Also known as a second mortgage, this option uses your home’s equity as collateral. Plus, any interest you pay is tax-deductible.
What other options do I have besides personal loans?
|Personal loan vs. Line of credit|
|Personal loan vs. Home equity loan|
|Personal loan vs. Mortgage|
|Personal loan vs. Business loan|
|Personal loan vs. Student loan|
|Personal Loan vs. Home equity line of credit|
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 entailed in borrowing from your retirement. Personal loans come with less risk but could end up costing you much more because of high interest rates and longer loan terms.