401(k) vs. personal loan: Comparing your options #CashNews.co

If you’re in need of some cash to make ends meet, it may be possible to tap your 401(k) plan in the form of a loan. Like a personal loan, a 401(k) loan offers a lump-sum disbursement, which you’ll pay back over a fixed repayment term. But beyond that, comparing a 401(k) loan to a personal loan and other alternatives is like comparing apples and oranges.

If you’re considering tapping your retirement savings as a last resort to cover basic expenses, here’s what you need to know about how they work and whether borrowing from a 401(k) personal loan is right for you.

A 401(k) loan is a type of loan that allows you to borrow money from your retirement plan. If your employer allows 401(k) loans, you can request one through your plan administrator. If approved, the administrator will sell some of your investments and disburse the cash to you.

Like a personal loan, a 401(k) loan can be used to pay for pretty much anything (like car repairs, medical bills, vacations, education expenses, travel, and more). It can also help you reach other financial goals, like consolidating high-interest debt to pay it off sooner or reducing your debt-to-income ratio for a mortgage.

However, a 401(k) loan is different from a personal loan. In fact, the loan terms are unique. Here’s a quick summary.

• Loan amounts: You can generally borrow up to 50% of your vested account balance or $50,000, whichever is less. If 50% of your balance is less than $10,000, your employer may provide an exception, allowing you to borrow up to $10,000.

• Repayment: Regardless of how much you borrow, you’ll have five years to repay the loan. You’ll need to make payments at least quarterly, but you can typically make payments via payroll deductions. If you use the funds to buy a primary residence, you may qualify for a longer repayment period. If you leave your employer, however, you’ll need to repay the loan in full by the tax filing deadline for the tax year in which your plan administrator offset your account due to nonpayment.

• Interest rate and fees: Interest rates on 401(k) loans tend to be low, and the interest you pay goes into your account instead of to a lender. You’ll most likely pay the current prime rate plus an extra 1% or 2%. That said, some employers may charge an application or maintenance fee while the loan is outstanding.

• Credit requirements: There’s no credit check when you apply for a 401(k) loan because you’re essentially borrowing from yourself.

• Default consequences: If you can’t repay your loan, the IRS will treat the unpaid balance as an early withdrawal. As a result, you may be subject to income taxes and a 10% penalty on the amount. The default won’t impact your credit because the loan isn’t reported to the credit bureaus.

Additionally, there are other factors to consider when taking out a loan against your retirement savings.

The potential advantages and disadvantages of a 401(k) loan include:

• Accessible with bad credit: You don’t need to worry about your credit score impacting your approval odds or interest rate. Depending on your situation, a 401(k) loan could be much more affordable than the alternatives.

• No taxes and penalties if you pay on time: Another way to tap your retirement account is to simply take an early distribution. But unless you qualify for an exception, that option can be costly, triggering income taxes and a 10% early withdrawal penalty.

• Flexible repayment: While there is a timeline for loan repayment, you’ll get a little more flexibility compared to personal loans. Instead of a fixed monthly payment, you just need to make sure you pay at least once quarterly and repay the debt in full within five years.

• Default is expensive: While interest rates tend to be low, defaulting can cost you far more than other loan options in the form of taxes and penalties.

• Lost earnings: Because you’re taking money out of your 401(k), you’re missing out on the gains those funds could be earning if they stayed put. Your payments will be reinvested as you go, but five years is still a long time not to have the full amount generating gains. What’s more, some plan administrators may not let you make additional contributions to your account until you’ve paid off the loan.

• You may not have the option: You can’t take out a loan from a 401(k) plan if you’re not currently employed with the company that sponsors it. Even then, not all employers allow 401(k) loans. If your employer does, the amount you can borrow may be limited based on how much you have vested in your account — in some cases, employer contributions may not vest and be accessible to you for several years.

If you’re deciding between a 401(k) loan and a personal loan, it’s often best to avoid tapping your retirement for anything other than financial necessities.

If you’re facing costly medical bills or a significant amount of high-interest credit card debt, a 401(k) loan could be an inexpensive choice, at least in the short term. That said, it’s important to consider the risks associated with 401(k) loans before you pull the trigger and apply.

• Your budget: Depending on how much you plan to borrow, run the numbers to determine whether you can afford to pay off the loan within the standard five-year repayment term.

• Your job stability: If you’re concerned about being laid off or don’t plan on sticking with your current employer for the next several years, the potential tax implications of defaulting may be too risky.

• Your credit history: If your credit needs some work, a 401(k) loan may be your only affordable option.

• Your retirement progress: Depending on how old you are and how much you have saved, the impact of a 401(k) loan on your return potential may or may not be notable. If you’re well into your career and you’ve saved a significant amount, for instance, a small loan may not affect your savings goal. But if you’re just starting out in your career and your employer won’t let you make contributions during repayment, it could set you back significantly.

Depending on your financial situation, it may not be a wise decision to take out a 401(k) loan. Fortunately, there are other options available.

Before applying for a 401(k) loan, research and compare your options to ensure you pick the right one for your situation and needs. Here are some to consider.

You can use personal loan funds for just about anything you want, with loan amounts ranging from under $1,000 to $100,000, depending on the lender. You’ll typically have between one and seven years to repay the loan. If you have good credit, you may even be able to secure a single-digit interest rate with some of the best personal loans.

Unlike 401(k) loans, there are no tax consequences with a personal loan, and your eligibility and repayment terms aren’t tied to your employment. That said, you typically need good or excellent credit to secure favorable terms. Also, some lenders charge origination fees, which can range from 1% to 12% of your loan amount.

Credit cards can offer a wide range of benefits, some of which can come in handy in a pinch. With a 0% APR credit card, for instance, you can avoid interest charges on new purchases or balance transfers for a period of six to 21 months, depending on the card. For balance transfers, they usually charge a balance transfer fee of 3% to 5% of the transfer amount.

Just keep in mind that 0% APR credit cards typically require good or excellent credit to get approved. Additionally, you won’t know what your new card’s credit limit will be until you get approved, so there’s no guarantee you’ll get the amount you need. Also, racking up a high balance on the new card could potentially damage your credit score until you pay it down.

Dig deeper: The best credit card picks for April 2024

If you own a home and have significant equity in it, you may be able to tap some of that equity in the form of a home equity loan or home equity line of credit (HELOC). A home equity loan is an installment loan — similar to a 401(k) loan or personal loan — while a HELOC is a revolving line of credit that works like a credit card.

Both of these options can have repayment terms of up to 30 years, and they typically have lower interest rates than personal loans and credit cards — though you typically need great credit to qualify for them. If you use the funds to buy, build or substantially improve your home, you may also be able to deduct the interest you pay on your tax return.

However, they can also come with high closing costs, and the amount you can borrow will be limited based on how much equity you have. Finally, if you fail to repay the debt, you may lose your home.

Learn more: HELOC vs home equity loan

If your credit is in poor shape and you’re struggling to keep up with debt payments, consider consulting with a credit counselor who can provide you with free personalized financial advice. They may even recommend a debt management plan for unsecured debt, like credit cards, which can help make your payments more affordable through lower interest rates and monthly payments.

However, these plans typically come with modest upfront and ongoing fees, and you may be required to close your credit card accounts. If you’d like to speak with a credit counselor, you can find one through the National Foundation for Credit Counseling or the Financial Counseling Association of America.

If you’re unemployed, you may have a hard time qualifying for any type of loan without a steady income. Learn about how to qualify for unemployment benefits and contact the unemployment office for the state where you live to get the assistance you need.

Because taking out a 401(k) loan can be risky, make sure you’re exploring all of your available options first.

1. Check your credit score to get an idea of your creditworthiness. Many credit card companies, banks, and credit unions offer members free credit score tracking.

2. Evaluate your options. For example, you can search for a lender or other financial institution that doesn’t mind a poor credit history. Or, you may even find a loan or other credit product that fits your situation even better. Pro tip: A soft credit check can give you a better idea of your approval odds without hurting your credit score.

3. Carefully consider the benefits and drawbacks of each. In particular, focus on the risks associated with each choice, especially if you’re concerned about long-term financial stability.

4. Shop around. Compare several lenders or creditors to ensure you get the best offer available.

While this requires a little extra work on your part, your financial future is worth it. You might find that a 401(k) is the best option for you after all. Or, you might find something else that better fits your needs (and wallet).