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When you’re in a pinch and need some cash, it can be tough to know which loan is right for you.
Do you go with a 401k loan or a personal loan?
Both have their pros and cons, and it can be hard to decide which is the best option for your unique financial situation.
In this post, I break down the differences between a 401k loan vs. personal loan so that you can make an informed decision about which one is right for you!
Table of Contents
401k Loan vs. Personal Loan | Finding The Best Option For You
Why Take Out Either Type Of Loan?
The main reason most people take out one of these types of loans is to consolidate debt.
You might have built up some high interest debt and are looking to pay it off with a lower interest rate loan.
Other uses for this money could be for home improvements, a new car, medical expenses, or other reasons.
Just know that these are not the only two loan options you have.
There are many more out there that might be better depending on your financial situation.
What Is A 401k Loan?
A 401k loan is a loan that is taken out against your retirement savings.
The money you borrow is not taxed, and you usually have up to five years to repay the loan back to your retirement account.
You are charged interest on the loan, but there are two pieces of good news here.
First, the interest rate is lower than most other loan products.
Second, since you are borrowing money from your own retirement savings and not from a bank, you actually pay yourself the interest back into your 401k plan.
Now the bad news.
If you don’t have a lot of money in your 401k, then you won’t be able to take out very much money.
For example, if you have a $10,000 vested account balance, you can only take a maximum of $5,000 out.
And if you don’t repay the loan within the five year window, you owe Federal Income Tax on the unpaid loan, and this tax amount depends on your income tax rate.
In addition to the income tax, you also pay a 10% early withdrawal penalty on the unpaid loan balance too.
Finally, know that you can get money from your 401k using a hardship withdrawal.
This feature avoids any debt repayment plan as you are not borrowing, you are simply withdrawing money.
There is a 10% penalty and strict rules for what actually qualifies as a financial hardship.
Pros Of 401k Loan
No credit check. Since you don’t go through a bank, there is no credit check. So even if you have poor credit, you can get a 401k loan.
No impact to credit history. In the event you default on your loan, there is no reporting to the credit bureaus since you are borrowing from yourself. As a result both your credit score and credit report will remain clear.
Easy repayment terms. Loan repayments are made through payroll deductions, so you are guaranteed to never miss a payment.
Fast approval. I many cases you can get access to the cash by the next business day.
Cons Of 401k Loan
Borrow money from yourself. While it is great to cut out the bank, since you are borrowing your own money, it misses out on compounding interest if you just kept in your retirement savings plan.
Limits to loan amount. Most 401k loans limit the amount you can borrow. This is usually 50% of the vested balance or $50,000 whichever is less.
Consequences if you lose your job. If you leave your job or are laid off before your 401k loan is paid back, you own the entire remaining loan balance by the time you file your income taxes.
Tax penalties. You owe taxes as well as an early withdrawal penalty if you do not pay back your loan in time.
Double taxation. According to current tax law, the money you use to repay the loan is after tax dollars, not pre-tax dollars. So you pay taxes on the money before you invest it into your 401k. But after you retire and withdrawal the money, you will be taxed on this money again. This “tax penalty” is something not many people talk about.
What Is A Personal Loan?
A personal loan is a loan that you get from a lending institution like a bank or credit union.
You can usually borrow up to $100,000 with these types of loans and the repayment terms are anywhere from two to seven years.
The interest rates on personal loans are higher than on 401k loans, but if you have a good credit score, you can get a decent rate.
There are two main types of personal loans, secured personal loans and unsecured personal loans.
Secured loans have you put up collateral to back the loan and as a result, you can get lower interest rates.
Unsecured loans have no collateral and as a result, tend to have higher interest rates.
Personal Loan Pros
Larger loan limits. Personal loan amounts range from $1,000 up to $100,000. This varies so be sure to ask each of the online lenders you get a quote from.
No collateral. You can get approved for a personal loan without having to put any collateral down.
Consistent loan payments. With a fixed interest rate, you know you will have fixed monthly payments for the life of the loan.
Use the money however you want. You are not required to use the money from personal loans for any specific thing. You can use it for debt consolidation, education expenses, a new car, home improvements, and more.
Flexible repayment terms. You can select a loan term from one year up to five years and even link your bank account so you can make automatic payments.
Personal Loan Cons
Higher interest rate. The interest rates on personal loans are higher than a 401k loan, but lower than your credit cards. In most cases, with decent credit, you are looking at an interest rate around 9%.
Longer approval time. Since you are borrowing money from a bank, you will have credit checks completed, which take time. In all you are looking at up to a week before you get approved.
Higher monthly payments. Since personal loans tend to be for up to 5 years, you will have a higher monthly payment than if you used your credit card.
Additional fees. Depending on your loan, you might be charged origination fees when you take out the loan, as well as prepayment penalties if you try to pay off the personal loan early.
Which Is Loan Is Better?
So which is a better option, a 401k loan or a personal loan?
This is a question that cannot be answered without knowledge of your financial goals and personal situation.
In most cases, I discourage people from taking a loan from their retirement assets.
This is because the money is for your retirement, not to pay off debt or home improvements.
Even though you are paying yourself the interest, you are still essentially robbing from your retirement plan because you will not end up with as much money had you left the money alone.
Also there is a high amount of risk if you decide to leave your job, get laid off, or are fired.
In any of these situations, you will be forced to make a large payment quickly, otherwise you will have to pay income taxes and penalties.
401k Loan vs. Personal Loan
|401k Loans||Personal Loans|
|401k loan offers a lump sum of money||Personal loan offers a lump sum of money|
|Can use the borrowed money for any reason||Can use the borrowed money for any reason|
|Maximum loan amount is $50,000||Maximum loan amount is $100,000 (varies by lender)|
|No personal guarantee/collateral required||Can take out secured or unsecured loan|
|No credit check required||Must qualify for loan|
|Loan default results in tax penalties||Loan default results in negative credit history|
For these reasons, I recommend a personal loan.
The downside is you have to get a credit check to be approved and you might have to pay an origination fee.
But your interest rate will be lower compared to credit cards, allowing you to save money if your goal is debt consolidation.
If you decide that a 401k loan is right for you, reach out to your human resources department and they can help you with getting the paperwork you need to apply.
If you think a personal loan is right for you, do your research to find a reputable one.
My favorite is PersonalLoans.com.
They are fair, offer competitive interest rates on their loans, and even have a great rating from the Better Business Bureau.
There are the differences between 401k loans vs. personal loans.
At the end of the day, only you can decide what is right for you.
The goal here was to help you make smarter financial decisions with your money so that you can get ahead financially.
So before you take out either loan type, be sure to do your homework and ask a lot of questions so you limit any surprises down the road.