You know the risks of borrowing from your retirement account, but the higher interest rates attached to personal loans makes you wary. If you’re curious whether a 401(k) loan or a personal loan would be better for your financial situation, take a closer look at the differences to be sure you can make an informed decision based off the facts.
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When you take out a 401(k) loan, you’re borrowing withdrawn from your retirement plan.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 |
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.
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.
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:
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.
If you’re still unsure what’s best for your situation, compare your personal loan options and learn more about 401(k) loans so you can make an informed decision.
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