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401(k) Loan Vs. Personal Loan: What’s The Better Option?

Andrew Dehan6-Minute Read

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If you’re in need of financial assistance through the form of a loan, there are many options you can choose from, including a 401(k) loan. Individuals with an established 401(k) retirement account may be eligible to take advantage of this loan if their employer offers it, but a personal loan may be a better fit for your situation.

Although both the 401(k) loan and personal loan have their pros and cons, it’s important to understand the difference between the two. Let’s break down the basics of 401(k) loans and personal loans so you can make the best choice for your needs.

What Is A 401(k) Loan?

If you have a 401(k) retirement plan, you may be eligible to borrow against it with a 401(k) loan, which uses the savings from your retirement account. The amount that you can borrow is dependent on your employer, but you may be eligible to take out upward of 50% (or up to $50,000) of your savings within a 12-month time frame.

A 401(k) loan is different from a withdrawal, which permanently removes the money you take out of your retirement savings. Money from a withdrawal can be used immediately, although taxes and fees are charged for this service. With a 401(k) loan, however, you’re essentially borrowing the money from yourself and paying it back over time. The payments and interest charges that you make on this loan will go back into your account.

401(k) Loan Repayment

In general, you have up to 5 years to repay your 401(k) loan. This term is eligible for extension if you’re using the funds to buy a home for your primary residence. The Internal Revenue Service (IRS) requires that loans be repaid on a quarterly basis, which includes principal and interest on the balance of the loan. These repayments are not considered contributions to your plan.

Failure To Repay The Loan

Should you miss the repayment deadline, your remaining balance will be taxed at the income tax rate and treated as income. Once the deadline for repayment is missed, your employer will file a 1099-R Form with the IRS.

What If You Leave Your Job?

Because these plans are employer-sponsored, you could be required to pay back your loan in full if you leave your job, are terminated or are laid off. Most retirement plan sponsors will require you to pay the loan back in full at the end of your employment contract. If you are unable to do so, you will likely have to pay hefty taxes and penalties. The balance is also treated as if you have defaulted on the loan and is labeled as a “deemed distribution”. You can avoid paying these penalties if you’re able to repay your loan in full before the next year’s tax return deadline.

Should I Borrow From My 401(k)?

Although a 401(k) loan may sound attractive, there are risks involved with borrowing from your retirement savings. The biggest risk factor is that doing so will decrease the amount that will be available to you when you retire, especially if you’re unable to replenish your account over time. Even after you fully pay back the loan, this money still has less time to fully mature.

You should also consider that you will be charged a 10% early withdrawal penalty fee on the balance if you are under the age threshold of 59½, or if you’re younger than 55 and retired. Before taking out a 401(k) loan, you should consider the implications this could have on your future. Depending on your circumstances, a personal loan might be more suitable for your needs.

How Does A Personal Loan Work?

A personal loan allows an individual to borrow a fixed amount of money in the form of an installment loan. Over time, that loan is paid back to the lender through monthly payments that apply to the principal and interest on the loan. When you apply for a personal loan, you will need to meet at least the minimum requirements for approval.

These loans are flexible in that they can be used for a variety of needs including major purchases, home improvements and debt consolidation. Personal loans typically have a fixed interest rate and no collateral requirements, so it’s an attractive option for borrowers.

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Is A 401(k) Loan Or A Personal Loan Better?

Let’s dive into a few of the pros and cons that set a 401(k) loan and a personal loan apart.

401(k) Loans

Pros

  • The approval process is easy. If your employer’s plan allows you to borrow against your 401(k), acquiring this loan should be relatively easy as there is no lender approval process or credit check required like there is with personal loans.
  • The interest payments are made to you. Because you are making payments on the principal and interest of the loan back to yourself, that interest goes directly back into your retirement account rather than being paid to a lender.
  • There are low interest rates. Depending on the lender, 401(k) loans may have lower interest rates than personal loans for borrowers with strong credit scores.

Cons

  • There are lower loan limits. 401(k) loans are limited to 50% or $50,000 (whichever is less) of your vested account balance. This limit may not be enough to cover your debts or expenses.
  • There could be future retirement plan implications. When you borrow from your 401(k), even if you intend to replace it, you lose the gains you had made over the life of the account, which could be difficult to recoup.
  • There are fees. With 401(k) loans, most plan providers will require you to pay fees for this service. If these fees are significant, it could make it less worthwhile to obtain a 401(k) loan that already has a low lending limit.
  • You’re required to be employed. To acquire a 401(k) loan, you’ll need to be employed. This can force many borrowers to feel trapped at their current place of employment until their balance is paid off. If you are fired or let go, then you may be forced to repay the loan sooner than expected or face taxes and penalties.

Personal Loans

Pros

  • You’ll have a fixed interest rate. Personal loans typically have fixed interest rates, which can help you maintain a consistent payment schedule for budgeting.
  • No collateral is required. Unlike other loans that require collateral such as a home, car or even retirement account, an unsecured personal loan does not have this requirement. This means that a lender cannot repossess anything from you if you are unable to continue making payments.
  • There are higher loan limits. With personal loans, lending limits are typically higher than that of 401(k) loans, which can make personal loans an attractive option for your financial needs with a higher price tag.
  • You’ll get your funding faster. You can expect to see your personal loan funds within 1 – 7 business days of approval, depending on your lender. With Rocket LoansSM same-day funding you can receive your money as soon as you’re approved.* 401(k) loans on the other hand, can take upwards of a few weeks to reach your account.

Cons

  • You’ll make higher payments. Compared to other loan options and credit cards, personal loans tend to have higher monthly payments and need to be paid off by the end of the repayment term. This can be difficult for some individuals who do not have the income to support larger monthly payments.
  • You may not be approved by a lender. To be approved for a personal loan, you’ll need to meet the lender’s approval requirements. This can be difficult for some individuals that do not have a strong enough credit score or those that have a high debt-to-income ratio (DTI).

401(k) Vs. Personal Loan: Limits And Requirements

Depending on your financial situation and repayment ability, the following limits and requirements of both loan options could influence your decision:

 

401(k) Loans

Personal Loans

Annual Percentage Rate (APR)

1% over the prime rate

Varies

Loan Amount

50% of vested account balance or $50,000 (whichever is less)

$2,000 – $45,000 (with Rocket Loans)

Repayment Term

5-year or less (unless used to fund a primary residence)

36 or 60-month (with Rocket Loans)

Credit Check

Not required

Required

Final Thoughts: Is A 401(k) Loan Or A Personal Loan Right For You?

When it comes to a 401(k) loan versus a personal loan, it’s important that you research and understand the terms, conditions and requirements of both options before deciding which option is best for you. You should also ask yourself what the future implications could be if you decide to borrow from your hard-earned retirement savings.

Leaning toward getting a personal loan? If you’ve made your decision and are ready to get started on the process, apply for a personal loan today.

*Same day funding is available for clients completing the loan process and signing the Promissory Note by 1:00 p.m. ET on a business day. Also note, the ACH credit will be submitted to your bank the same business day. This may result in same day funding, but results may vary, and your bank may have rules that limit our ability to credit your account. We are not responsible for delays that may occur due to an incorrect routing number, an incorrect account number or errors of your financial institution.

Apply For A Personal Loan.

Explore your options today and see what's possible in one simple click.

Apply For A Personal Loan.

Explore your options today and see what's possible in one simple click.

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Andrew Dehan

Andrew Dehan is a professional writer who writes about real estate and homeownership. He is also a published poet, musician and nature-lover. He lives in metro Detroit with his wife, daughter and dogs.