Understanding 401(k) Loans and Personal Loans: Which One is Right for You?

When faced with a large expense or an emergency, borrowing money can be a necessary step. Two common options are 401(k) loans and personal loans. Each has its own set of benefits and drawbacks, and the right choice depends on your specific needs and circumstances. In this blog, we’ll explore both options in detail to help you make an informed decision.

What Is a 401(k) Loan?

A 401(k) loan allows you to borrow money from your retirement savings. If your 401(k) plan administrator offers this option, the application process is often straightforward. Typically, you can request the loan by logging into your account through your plan administrator’s website and specifying the amount you want to borrow. You may take up to 50% of your vested account balance, up to a maximum of $50,000, within a 12-month period.

Once you authorize the loan, the money is usually included with your next paycheck, and the funds can be used for virtually any purpose. You’ll need to repay what you borrowed within five years, with interest, unless you use the funds to buy a primary residence. The interest rate is determined by the fund administrator and is typically calculated by adding one or two percentage points to the current prime interest rate. Payments are made at least quarterly. However, if you lose or leave your job, the entire loan balance may become due by the tax-filing deadline for the year you received the distribution.

If you don’t repay the money per your loan terms, the IRS will consider any unpaid balance a plan distribution. This could result in paying early withdrawal penalties and income taxes unless you qualify for an exception.

Pros and Cons of 401(k) Loans

Pros

• Easy application process: Getting a 401(k) loan is usually a matter of making a simple request, and plan administrators typically won’t review your finances to decide whether you qualify.
• Relatively low interest rate: The interest rate on a 401(k) loan is typically lower than what you’d find through a lender. Plus, that interest goes back into your own account—so you’re not paying it to a bank.
• No credit impact: Because there’s no credit check when you request a 401(k) loan, your credit score won’t impact your loan approval chances or interest rate. The loan itself won’t affect your credit, either, because it’s not reported to the credit bureaus.

Cons

• Losing out on earnings: When you take money out of your 401(k), you miss out on any gains you could potentially earn on those funds if they had stayed invested. The money will be reinvested when you pay it back, but the loan can still put a dent in your retirement savings that you might not recoup, especially if you take a large loan, take the full five years to repay it, or take a loan during a bull market.
• Default can be expensive: If you lose or leave your job, you may be required to repay the entire loan balance by the next tax-filing deadline. And if you can’t repay the loan, then the balance will be considered a distribution, which potentially comes with income taxes and penalties.
• Might not be an option: You can only take out a 401(k) loan if your employer allows it and you’re still employed at the company that sponsors it. Plus, the low loan limits could mean you won’t be able to borrow much.

What Is a Personal Loan?

A personal loan is a type of loan that’s provided as a lump sum and repaid in installments over time, usually two to seven years. This type of financing is very flexible because you can use the funds for nearly any purpose, such as consolidating high-interest debt or making home improvements. You can also potentially borrow a large amount: These loans typically range from around $1,000 to $50,000, with some going as high as $100,000.

The application process is more involved compared to taking out a 401(k) loan. You’ll need to find a lender, submit a loan application, and authorize a hard credit pull. The lender may also need documentation, such as tax forms and pay stubs, to verify your income. Additionally, some lenders restrict how you can use the loan, so you’ll need to check the terms and conditions.

If approved, you’ll receive the loan funds in your account and then will start repaying the loan with interest.

Pros and Cons of Personal Loans

Pros

• Potentially high loan amounts: Depending on the lender’s loan limits and your creditworthiness, you may be able to borrow more than you would with other options, including a 401(k) loan.
• Won’t affect your assets: Personal loans are often unsecured, meaning you won’t have to put your assets at risk. You also won’t take away from your retirement savings and risk losing out on the power of compounding.

Cons

• Impacts your credit: Applying for a personal loan adds a hard inquiry to your credit reports, which may have a slight negative impact on your credit scores. And while making on-time payments can help keep your credit healthy, any defaults may have the opposite effect.
• Relatively high costs: The average interest rate on a 24-month personal loan was 12.35% as of November 2023. This makes personal loans more expensive than 401(k) loans.

Should I Get a 401(k) Loan or a Personal Loan?

A 401(k) loan and a personal loan are both viable options when you need to borrow money. Borrowing from your retirement account is typically quick, requires no credit check, and comes with lower costs compared to a personal loan. However, a personal loan may be the way to go if you need to borrow a larger amount, you want a longer repayment term, or you’re uncomfortable with the thought of risking potential stock market gains.

When making your decision, consider:

• The amount you need to borrow
• A loan term that works for you
• Your job stability
• Your credit history
• How much you’ve saved in your 401(k)

401(k) Loan vs. Personal Loan

Alternatives to 401(k) Loans and Personal Loans

A 401(k) loan and a personal loan aren’t the only ways to borrow money. You may also consider the following:

Home Equity Loans

Home equity loans allow you to borrow a lump sum of money that you repay in installments over time with interest. Your home acts as collateral, which may help you qualify for a low interest rate—but it also puts your home at risk.

Home Equity Lines of Credit

Home equity lines of credit give you access to a revolving line of credit that you can draw from as needed and then repay with interest. This type of financing also uses your home as collateral and typically comes with a variable interest rate.

Introductory 0% APR Credit Cards

Introductory 0% APR credit cards offer a low interest rate on purchases, balance transfers, or both for a set period of time, such as 12 to 21 months. Qualification depends on your creditworthiness, income, and other factors.

The Bottom Line

Borrowing money is a big decision, and the financing you choose can affect your monthly payments, borrowing costs like interest and fees, and the impact on your credit. A strong credit history may boost your approval odds and help you receive good loan terms.

Checking your credit score and report for free through Experian can help you see whether you have room to improve. As long as you pay your bills on time every month without fail, and attend to the other factors that contribute to credit scores, monitoring your credit scores will be a satisfying endeavor.

For any mortgage service needs, O1ne Mortgage is here to help. Call us at 213-732-3074 to speak with one of our experienced loan officers. We are committed to providing you with the best service and helping you find the right loan option for your needs.