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If you’re in a financial bind, a 401(k) loan allows you to borrow from yourself instead of a bank or a credit card. While a 401(k) loan helps you save on interest payments—you’re paying yourself instead of a financial institution—it’s not free of costs. Anytime you withdraw money early from your 401(k), you’re missing out on compounding growth.
What Is a 401(k) Loan?
A 401(k) loan is a loan you take out from your own 401(k) account. They work like normal loans—you pay origination fees and interest—only you’re borrowing money from yourself. According to Vanguard, 78% of 401(k) plans permit participants to take out 401(k) loans, and about 13% of plan participants have an outstanding 401(k) loan.
If you need money, you might consider taking a loan from your 401(k) if:
• You want a lower interest rate. 401(k) loans still charge interest. But the amount you pay may be less than on a loan you take out with someone else. 401(k) loan interest rates are based on the prime rate, an interest rate adapted from Federal Reserve loaning guidelines. 401(k) loans will normally be a percentage point or two above this rate, which may be lower than the rate you could get at a bank.
• You’d prefer to pay interest to yourself. No one likes paying banks and credit card companies interest. While you’re still on the hook for interest payments with a 401(k) loan, you get to pay it back to yourself instead of someone else.
• You want looser credit requirements. If your credit score prevents you from getting the best rates on loans, you may opt for a 401(k) loan. Depending on your employer, you may not even need a credit check to borrow from your 401(k).
You might want to avoid a 401(k) loan if:
• You may leave your job soon. If you anticipate parting ways with your employer soon, no matter the reason, you probably don’t want to take out a 401(k) loan. Anything you borrow from a 401(k) may have to be repaid as soon as you’re no longer employed by a company. If your company doesn’t have a specific policy on repayment, you’re subject to federal standards, which require you repay the loan by tax day, generally April 15 of the following year. If you can’t repay by then, the loan is treated as an early withdrawal and may be subject to taxes and a 10% penalty.
• You’d prefer not to jeopardize your retirement savings. While 401(k) loans have to be repaid, you might pursue other loans if you want to give your money the most time to grow and compound. You’ll pay yourself back in interest, but for the time that your money is out of your 401(k), it won’t be earning compound returns. This may put an unintended dent in your retirement savings, which is why many consider a 401(k) loan a last resort.
401(k) Loan Rules
How Much Can You Borrow from Your 401(k)?
In general, you can borrow the greater of $10,000 or 50% of your vested account balance up to $50,000. You are limited to the balance in your current company’s 401(k), not the collective balance of all of your retirement accounts. You may, however, be able to roll over funds into your current 401(k) to increase the amount you can borrow. You are limited to borrowing from the assets in your current employer’s 401(k) plan.
How Long Do You Have to Repay a 401(k) Loan?
You generally have up to five years to repay your 401(k) loan, and you must make at least quarterly repayments. You may be able to get longer loans under special circ*mstances, like when you use a 401(k) loan for your primary residence. Your employer may set different terms for any of the above, so make sure to check with your plan administrator before you withdraw money from your 401(k).
Regardless of the requirements of your plan and company, you may choose to make more frequent repayments or to borrow money for a shorter amount of time. Paying off a 401(k) early minimizes the opportunity cost of having money not compound in your retirement accounts. It also helps protect you from the consequences of not repaying a 401(k) loan if you suddenly lose your job.
Remember: Your company determines when you must repay your 401(k) loan by if you’re no longer employed. While your company may allow repayment up until you file taxes for the current year, you must repay your loan by then. Otherwise, you may owe taxes or an early withdrawal penalty on the amount you borrowed.
Steps to Get a 401(k) Loan
If you’ve decided a 401(k) loan is the right move for you, follow these steps to get your loan:
1. Talk to Your Employer About Loans from Your 401(k) Plan
Find out if your employer allows 401(k) loans. If you can’t find an answer in your plan documents or plan web portal, speak with your human resources representative or 401(k) plan representative.
2. Learn About the Terms
While the government sets limits on borrowing and other items, plan administrators can determine their own requirements within those. Review how much you can borrow and when you have to repay the loan. Be sure to pay attention to the interest rate so you can compare it to other borrowing options.
3. Fill out the Required Paperwork
Depending on the plan administrator, you may be able to complete this step online. Read all the fine print and make sure you understand when you need to make payments.
4. Receive the Loan
Depending on your employer and 401(k) plan administrator, you may receive the funds directly in your bank account or as a check.
5. Make Regular Payments on the Loan
You may have to make monthly or quarterly payments, depending on your plan. These may come from your bank account or paycheck. Aim to pay off your 401(k) loan as quickly as you can to get your retirement funds back in your account.
6. Keep Making Regular Retirement Plan Contributions
If you can, maintain your regular retirement plan contributions. A steady, regular stream of additional contributions prevents you from taking a pause on your retirement savings. Otherwise, a 401(k) loan might doubly impact your nest egg by depriving you of growth of new and past contributions.
Should You Get a 401(k) Loan?
Whether a 401(k) loan is the right for you depends on your situation. For some borrowers, especially those with poor credit, a 401(k) loan can help you avoid high-interest debt. As long as you can afford to repay the loan, it’s generally better to be paying interest to yourself than to someone else.
But 401(k) loans aren’t without risks, the greatest being that if you can’t afford to repay the loan or leave your job early, you may have your loan converted to an early withdrawal. These carry the same possible 10% penalty and tax consequences as any other early withdrawal from a 401(k).
You’re also potentially missing out on up to five years of investment gains, depending on the length of your 401(k) loan. Remember that over the long term, the S&P 500 has gained an average of about 10% every year. While you could get lucky and make your 401(k) loan during an extended dip or recession, the longer your money is out, the more growth you may miss.
Before taking a loan from your 401(k), be sure to consider all other options, like emergency funds, taxable investment accounts, low-cost loans from personal lenders, HELOCs if you have home equity or any 0% APR credit cards you may be eligible for. While a 401(k) loan can make sense in some circ*mstances, it’s not the best choice for everyone.
