What Is an 401(k) loan? Is It a Good Idea?

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What is an 401(k) loan and is It a Good Idea?
The risk of a 401(k) loan can derail your retirement savings. Weigh the risks and consider other financing options.


Updated on January 31st 2023.

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Takeaways from Nerdy
The standard 401(k) plan allows you to borrow up 50% of the amount for up to 5 years, with a maximum limit of $50,000. The cost to borrow is relatively low, and the interest paid returns to the borrower. As the loan is being made, you miss out on potential stock market gains plus the compounding interest which increases your retirement savings. It is recommended that a 401(k) loan is best considered after other options are exhausted.




Many 401(k) plans allow users to borrow against their savings for retirement. It's a low-interest loan option that can be used to cover a large expense, but you should be careful. A 401(k) loan can mean long-term retirement losses or penalties if you're unable to pay back the loan.
What is what is a 401(k) loan?
Employer rules vary, but 401(k) plans typically permit users to borrow up to half of their retirement account balance or $50,000 -- the lesser amount -for up to five years.
When other borrowing options are ruled out and you're not sure what to do, it's possible to take out a 401(k) loan might be an option for paying off high-interest debt or covering the cost of a necessity however, you'll need a strict financial plan to repay it on time and avoid penalties.
Pros and pros and 401(k) loan
Think about the pros and cons prior to making a decision to borrow.
Pros
401(k) loans usually have single-digit interest rates, making them less expensive as credit card loans. In general, interest is equal to one percentage point.
The interest you pay goes back into your account.
There's not a credit check, and there's no an impact on your credit score.

Cons
It derails the retirement funds you have saved, and sometimes significantly.
If you quit your job, you must pay back the loan quickly.
Risks include tax consequences and penalties.

The true price of the 401(k) loan
If you take money from your retirement account is not eligible for market gains and the magic of compounding interest.
According to , borrowing $10,000 from a 401(k) program over five years would mean sacrificing an investment return of $1,989 and ending the five years with a debt of lower by $666. This assumes you pay 5% interest for the loan and the investments in the plan would have earned 7percent.
However, the expense to your retirement account doesn't end there. If you've got 30 years until retirement, that unpaid $666 could have increased to $5,406, according NerdWallet's (assuming that same rate of return is 7%, and compounding monthly).
In addition, you could lower the amount of your 401(k) contributions while making payments on the loan through the program. This will further decrease the savings you have made in retirement.
401(k) loans are tied to the company you work for.
If you quit your job, while you are repaying the 401(k) loan, you have to pay the balance instantly or in a shortened time frame. Some plans require immediate repayment in the event that you quit prior to when the loan is fully paid.
If you're not able to repay the loan and you're not able to repay it, the IRS would consider any amount not paid as a distribution and count it as an income item when filing the tax year's return. Additionally, you'll be charged 10% early withdrawal penalty if you're younger than 59 1/2.
Do you want to use the 401(k) loan to pay off debt?
Before you take out the 401(k) loan to pay off debt, think about other options that won't impact the savings you have in retirement.
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Debt consolidation lets you roll several high-interest debts to a balance-transfer credit card, or personal loan with lower interest rates. You then have a single monthly debt payment and less total interest cost.
Alternatives to debt relief If you're unable to pay off your debts that are not secured such as credit cards, personal loans and medical expenses -in the next five years or if the total debt equals more than 50% of your income it could be necessary to consolidate. The best choice is to speak with an attorney or credit counsellor regarding credit counseling, which includes credit counseling.
Bankruptcy: Chapter 13 bankruptcy and debt management plans are required for five years of repayment at most. After that, your remaining consumer debt is wiped out. Chapter 7 bankruptcy discharges consumer debt immediately.
In contrast to consumer debt, the 401(k) loan isn't forgiven in bankruptcy.
>> MORE:
401(k) loan alternatives
Due to the risks that come with 401(k) loans, first look at other financing options.
Alternatives for large expenses
Personal loans They can be used a for almost anything, from home repairs, debt consolidation emergency medical bills, and other expenses. Loan amounts are from $1,000 to $100,000 and the interest rates are between 6% and 36 percent. They're usually repaid in monthly installments over a term from two to seven years.
The loans are not secured, which means there is no collateral requirement. The lender will use information about your credit and financial history to determine whether you're eligible as well as your loan's annual percentage rate.
>> MORE:
See if you pre-qualify for an individual loan - without affecting your credit score
Simply answer a few questions to get customized rate estimates from several lenders.


Loan amount
on NerdWallet








Equity home loans and credit lines The line of credit or home equity loan or line of credit is a low-interest way to fund home repairs and other emergency. If you decide to take one of these the best option, you could typically borrow the maximum amount of 80% your property's value, less what you owe on your mortgage. The rates are usually within the single digits, and repayment terms are between 10 and 20 years.
Home equity loans and lines of credit require you to put up your house as collateral for the loan, meaning the lender can be able to take it if you don't pay back. The biggest difference between these types of financing is their borrow-and-repay structures.
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Transfer of balances at 0% APR credit card alternative is to transfer the high-interest debt into a credit card that has a zero-interest promotional period. It is generally necessary to have good or excellent credit to be eligible (690 or better credit score) and the amount you're able to transfer is contingent on the credit limit the card issuer gives you. If you qualify then you have to pay off the balance within the interest-free promotional period -- usually 15 to 21 months -- in order to keep from paying the card's (often excessive) annual APR.
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Alternatives to small-scale costs
: It's worth asking an amiable friend or family member to take out a loan to to bridge a gap in income or pay for an emergency. There's no credit check when you use this method and you can draft a contract with the lender, which outlines the interest and how the loan will be repaid.
Apps for cash advances allow users to borrow as much as one hundred dollars, and repay it on their next payday. These advances are a quick option to pay for a cost, but urgent cost. There's no interest. However, the apps often tack on charges for quick funding and will ask for tips that are optional.
When you're working on repairing an automobile or laptop, or buying a new mattress, the retailer may offer buy nowand plan to pay in the future. This type of payment plan lets you break up your acquisition into smaller generally biweekly installments. A bad credit score (a score below 630) could not stop you from being eligible since there's typically only a soft credit check.
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About the writer Annie Millerbernd is a personal loans writer. Her work has been published on The Associated Press and USA Today.







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