401(k) Loans vs. Personal Loans

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Updated: November 7, 2024

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If you suddenly need quick access to funds, 401(k) loans and personal loans are two options worth considering. A 401(k) loan allows you to borrow from your retirement savings with the benefit of repaying yourself with interest, while a personal loan provides quick funds without tapping into retirement savings but typically comes with higher interest rates.

Both 401(k) loans and personal loans serve different financial needs and preferences, offering distinct benefits and drawbacks. Choosing the right option for you requires understanding how each one works and aligns with your particular financial situation.

Key Takeaways

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A 401(k) loan allows you to borrow against your retirement savings. With this type of loan, you are both the borrower and the lender.

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A personal loan usually doesn’t require collateral and can be used to consolidate debt, finance a major purchase or fund home improvement projects.

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Deciding between a 401(k) loan or a personal loan depends on your specific needs. It’s wise to weigh each option’s benefits and drawbacks before choosing.

What Is a 401(k) Loan?

A 401(k) loan allows you to borrow money from your own retirement savings in your 401(k) account. You can generally take out up to 50% of your vested account balance or $50,000, whichever is less, with a repayment period up to five years. With a 401(k) loan, the interest you pay is deposited back into your 401(k) account, which means you are paying the interest back to yourself.

There is an exception to the 50% limit if your vested account balance is relatively small. If 50% of your balance is less than $10,000, you may still be able to take out up to $10,000 as a loan.

To obtain a 401(k) loan, you usually need to apply through your plan's administrator. The process is often more straightforward than that of traditional loans as it typically does not involve credit checks. The funds you receive can be used for a variety of purposes, such as home repairs, medical expenses or even debt consolidation.

Features of a 401(k) Loan

A 401(k) loan offers a way to access your retirement funds early, directly borrowing from your own savings with distinct terms for borrowing limits, interest rates and repayment.

General requirements

To qualify for a 401(k) loan, you must have a sufficient vested balance in your 401(k) plan. Some plans may set a higher minimum loan amount, so it's essential to check the specific rules of your plan. The availability of a 401(k) loan also depends on whether your employer's plan offers it as an option, so not all participants may have access.

Interest rates

Interest rates on 401(k) loans are generally competitive, often fixed at one or two percentage points above the current prime rate. This remains constant throughout the term of the loan, providing predictability in payments. Note that although the rates are typically lower, they are still a cost to consider.

Repayment

Repayment of a 401(k) loan is usually done through payroll deductions, spread evenly over the loan term, which is generally up to five years. It’s critical to maintain employment with the company during the loan period, as leaving the job could accelerate the repayment schedule. If the loan is not repaid on time, it may be treated as a taxable distribution and could incur a 10% early withdrawal penalty if you are under 59½ years of age.

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MONEYGEEK EXPERT TIP

When an employee leaves a job, whether voluntarily or involuntarily, there is typically a grace period during which the outstanding balance of the 401(k) loan must be repaid to avoid taxes and penalties. This grace period is usually around 60–90 days but can vary depending on the employer's plan rules. During this period, the employee may be able to repay the loan in full or set up a repayment plan to avoid default. If eligible, a loan may be rolled over to a new employer's 401(k) to continue paying per the original terms. — Alvin Yam, CFP®

Pros and Cons of a 401(k) Loan

401(k) loans offer a unique borrowing option, blending accessibility with several benefits. However, like all financial tools, they also come with their own set of drawbacks.

Pros of a 401(k) Loan

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    No Credit Check Required

    When you borrow from your 401(k), there’s no credit check involved. This is beneficial if you have less-than-ideal credit or are trying to avoid further inquiries that could potentially lower your credit score. As a result, accessing funds can be quicker and easier than traditional loans, where creditworthiness is a significant factor.

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    Lower Interest Rates

    The interest rates on 401(k) loans are typically lower than those on personal loans or credit cards, especially if you have average or below-average credit. Since the loan is secured by your retirement account, it poses less risk to the lender, resulting in more favorable interest rates. Additionally, the interest paid goes back into your 401(k) account, which can partially offset the cost of borrowing.

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    Avoid Taxes and Penalties

    Withdrawing funds from your 401(k) before retirement usually incurs heavy taxes and penalties. However, a 401(k) loan allows you to access these funds without incurring early withdrawal penalties or having to pay taxes on the amount — as long as the loan is repaid according to the agreed terms and timelines.

Cons of a 401(k) Loan

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    Risk of Default

    If you leave your job or are terminated, most 401(k) plans require the loan to be repaid in full by the next tax filing deadline or it may be considered a default. In the event of default, the outstanding balance is treated as a taxable distribution and you may also face a 10% early withdrawal penalty if you are under the age of 59½.

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    Missed Investment Growth

    When you borrow from your 401(k), the withdrawn amount is no longer invested in the market, potentially missing out on significant investment returns. The cost of these missed opportunities can outweigh the benefits of the loan, especially during periods of strong market performance. This can have a lasting impact on the growth of your retirement savings.

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    Limited Availability

    Not all 401(k) plans offer the option of a loan. Availability depends on your employer’s plan provisions. Even if loans are offered, there may be restrictions on the amount you can borrow or the specific reasons for which you can take out the loan. This limitation means that some employees might not have access to this form of borrowing when they need it.

When to Get a 401(k) Loan

Getting a 401(k) loan should generally be a rare decision, yet it can be a sensible choice in scenarios where you urgently need a significant amount of cash. Here are situations when considering a 401(k) loan might make sense:

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    High-Interest Debt Consolidation

    If you're facing high-interest debt such as credit card balances, a 401(k) loan can be a practical option for consolidation. By using the loan to pay off multiple debts, you can replace them with a single, lower-interest loan. This can reduce your overall interest payments and simplify your financial management by having just one monthly payment.

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    Emergency Expenses

    For unexpected financial emergencies that require immediate funds, such as significant medical bills or urgent home repairs, a 401(k) loan can provide quick access to cash without the lengthy approval processes typical of other loans. This is particularly advantageous if you do not have an emergency fund or other savings to draw from.

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    Prevention of Foreclosure or Eviction

    In situations where your home is at risk due to foreclosure or eviction, a 401(k) loan can be a lifeline. Accessing these funds can help you make mortgage payments or settle dues that prevent losing your home. Since housing stability is crucial, using a 401(k) loan in such circumstances can be justified as a protective financial measure.

Alternatives to a 401(k) Loan

Before opting for a 401(k) loan, consider other financial alternatives that might better suit your situation without tapping into your retirement savings, such as:

  • Home Equity Lines of Credit (HELOC): If you own a home, a HELOC might be a viable option. This type of credit allows you to borrow against the equity in your home at a relatively low interest rate. You can draw funds as needed, making it flexible for ongoing expenses. Remember, since your home secures the loan, timely repayment is crucial to avoid risking foreclosure.

  • Home Equity Loan: Similar to a HELOC, a home equity loan also lets you borrow against the equity in your home but differs in that it provides a lump sum instead of a credit line. This option offers fixed interest rates and payments, making budgeting easier. It's suitable for larger, one-time expenses with predictable costs.

  • Credit Cards: For shorter-term financial needs or emergencies, credit cards can be a quick source of funds. If you qualify, some credit cards offer introductory periods with 0% APR, which can be useful for immediate, short-term funding without interest charges. However, standard interest rates post-introductory period can be high, so plan to pay off the balance before the promotional period ends.

  • Peer-to-Peer Lending: This option involves borrowing money through online platforms that match lenders with borrowers. Peer-to-peer lending can offer more favorable terms and interest rates compared to traditional banking, especially for those with higher credit scores. The application process is typically quick, and funds are usually available within a few days.

What Is a Personal Loan?

A personal loan is a type of unsecured loan provided by banks, credit unions and online lenders. It allows individuals to borrow a fixed amount of money from $500 to $100,000, which is paid back with interest in monthly installments over a set period of time, typically ranging from one to seven years.

Unlike secured loans, personal loans do not require collateral like a home or a car. The lender offers the loan based on the borrower’s creditworthiness, which is determined by their credit score, income level and other financial factors.

The interest rates for personal loans can vary widely depending on the lender and the borrower’s credit profile. A higher credit score typically results in lower interest rates. Once approved, the funds are usually disbursed as a lump sum, giving the borrower the flexibility to use the money as needed. This includes consolidating debt, funding large expenses like weddings or vacations, covering medical bills or undertaking home improvement projects.

Features of a Personal Loan

Personal loans are a convenient and flexible financial resource that can be tailored to meet a wide range of needs without requiring collateral. Here’s a breakdown of their key features:

General requirements

To qualify for a personal loan, lenders typically assess your credit score, income and debt-to-income ratio. A good credit score indicates to lenders that you have a history of managing debt responsibly, which can lead to more favorable loan terms.

Proof of income, through pay stubs or tax returns, is required to show you have the means to repay the loan. The debt-to-income ratio, which compares your monthly debt payments to your income, should ideally be below 36%, though some lenders may accept higher ratios.

Interest rates

Interest rates on personal loans can vary widely based on the lender and your credit profile. Fixed interest rates are common, which means your monthly payment remains the same throughout the life of the loan, simplifying budgeting. Some lenders also offer variable rates, which can fluctuate based on changes in the benchmark rate.

Repayment

Personal loans are typically repaid in fixed monthly installments over a period that can range from one to seven years, depending on the lender's offerings and the borrower’s preference. Early repayment options are available with some lenders without penalty, which can save on interest costs over time.

Pros and Cons of a Personal Loan

Personal loans can be a useful financial tool, offering several advantages along with some disadvantages.

Pros of a Personal Loan

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    Higher Borrowing Limits

    Personal loans often come with high borrowing limits, allowing individuals to access up to $100,000, depending on the lender. This allows you to consolidate significant amounts of debt under one loan or fund major expenses like home improvements or significant life events in one go, rather than relying on higher-interest alternatives or multiple lines of credit.

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    Predictable Repayment Schedule

    Personal loans typically come with fixed interest rates and a set repayment term, which means you'll have a predictable monthly payment throughout the duration of the loan. This makes it easier to budget and plan your finances, as you know exactly how much you need to pay each month and for how long.

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    No Collateral Required

    Unlike secured loans such as auto loans or mortgages, most personal loans are unsecured, meaning they do not require collateral. This is beneficial for borrowers who may not have significant assets to offer as security but who need access to funds. The absence of collateral simplifies the borrowing process and can make funds more accessible to a broader range of applicants.

Cons of a Personal Loan

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    Fees and Penalties

    Many personal loans come with additional fees, such as origination fees, which can add to the cost of borrowing. Some lenders also charge penalties for early repayment, which can discourage borrowers from paying off their loan early and reducing their interest burden. These fees and penalties can vary widely between lenders, making it important for borrowers to read the fine print before accepting a loan.

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    Hard Credit Checks

    When applying for a personal loan, lenders typically conduct a hard credit check to assess your creditworthiness. This type of credit inquiry can temporarily lower your credit score. Multiple hard inquiries in a short period can have a more substantial negative impact, which is crucial to consider if you are planning to apply for additional credit soon, such as a mortgage or car loan.

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    Restrictions on Fund Usage

    Although personal loans are versatile, some lenders may impose restrictions on how you can use the funds. For example, some loans might not be used for business purposes, investment opportunities or post-secondary education expenses. These limitations can make personal loans less flexible for borrowers who need funding for specific uses that are not covered.

When to Get a Personal Loan

Opting for a personal loan can be a strategic financial decision under the right circumstances. These include:

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    Consolidating Debt

    If you have multiple debts with high interest rates, such as credit card debt, consolidating these into one personal loan with a lower interest rate can save you money on interest payments. This also simplifies your finances by reducing the number of payments you need to manage each month.

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    Funding Large One-Time Expenses

    Personal loans are ideal for covering large, one-time costs such as weddings, vacations or significant home improvements. Using a personal loan for such expenses allows you to spread the cost over several years, making it more manageable within your budget.

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    Covering Medical Bills

    When faced with substantial medical expenses that aren’t fully covered by insurance, a personal loan can provide the necessary funds to pay for treatments without the need for immediate full payment. This can help manage health care costs more effectively, preventing more drastic financial measures like draining savings.

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    Relocation Expenses

    Moving to a new home, especially to a different city or state, can be expensive. A personal loan can help cover these costs, such as hiring movers, transportation and setting up your new home, which can be substantial and not always predictable.

Alternatives to a Personal Loan

Before deciding on a personal loan, it's worthwhile to explore other financing options that may better suit your financial situation. Here are some alternatives:

  • Credit Cards: For smaller or short-term expenses, credit cards can be a viable option, particularly if you can take advantage of promotional offers like 0% interest rates for an introductory period. This can be cost-effective for managing purchases or expenses if you are able to pay off the balance before the promotional period ends and higher rates apply.

  • Home Equity Loans or Lines of Credit: If you own a home with substantial equity, a home equity loan or a HELOC might be a better choice. These options typically offer lower interest rates compared to personal loans because they are secured by your home. They can provide a larger sum of money that is useful for significant expenses like home renovations or covering educational costs.

  • Savings or Emergency Funds: Drawing from your own savings or emergency funds is the most cost-effective alternative as it avoids interest charges and debt. Using your savings for unexpected or large expenses can prevent the financial strain of repayments and interest associated with loans.

  • Borrowing from Family or Friends: This can be an interest-free or low-interest option if available. Borrowing from someone you know allows for more flexible repayment terms and can save you from the formalities and costs of institutional lending. However, it's important to handle such arrangements with clear agreements and communication to avoid personal conflicts.

  • Negotiate Payment Plans with Creditors: If you're struggling with paying down your debt, speak to your creditors. Creditors may be open to negotiating payment plans or settling debts.

Comparing 401(k) Loans vs. Personal Loans

Both 401(k) loans and personal loans provide a way to access funds for various purposes, from handling emergencies to funding significant expenses. However, understanding their differences will help you in determining which option is the best fit for your unique financial situation.

401(k) Loans
Personal Loans

Interest rate

Interest rate is often one or two points above the prime rate.

Interest rate varies widely based on credit score and lender terms.

Loan amount

Up to $50,000 or 50% of vested balance.

Can vary widely, often up to $100,000, depending on lender and creditworthiness.

Repayment terms

Typically up to five years. If used for home purchase, it might be longer.

Generally between two to seven years, based on lender and loan amount.

Credit impact

Because there’s no credit check required, it doesn’t impact your credit score directly.

Requires a credit check, which can potentially affect your credit score both positively and negatively.

Uses

Flexible, but must be repaid if employment ends.

Flexible, but some lenders may impose restrictions.

How to Choose Between 401(k) Loans and Personal Loans

When deciding between a 401(k) loan and a personal loan, understanding your financial situation and long-term goals is crucial to making a choice that aligns with your particular needs. Here are some tips to help you choose between the two:

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    Know Your Credit Score

    Your credit score is a key factor in determining the terms and interest rates you qualify for on a personal loan. A high credit score can secure lower interest rates, making a personal loan more attractive. In contrast, a 401(k) loan might be preferable if you have a lower credit score, as it does not require a credit check.

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    Determine the Loan's Purpose

    Clarify what you need the loan for. If the expense is urgent and you lack sufficient emergency funds, a 401(k) loan might be quicker and easier, avoiding the potential credit score impact of a personal loan application. Conversely, if the loan is for consolidating debt or funding a non-urgent large purchase, a personal loan might offer more flexibility and potentially better terms.

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    Calculate How Much You Need

    Evaluate how much money you actually need to borrow. 401(k) loans are limited to 50% of your vested account balance or $50,000, whichever is less. If you need more than this, a personal loan might be the only option. Conversely, if the amount is smaller and can be comfortably repaid into your retirement fund, a 401(k) loan could be more suitable.

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    Evaluate the Importance of Retirement Savings

    Consider the impact on your retirement savings. Borrowing from your 401(k) means the borrowed amount isn’t earning investment returns until it's repaid. If preserving your retirement savings’ growth potential is a priority, steering clear of a 401(k) loan might be wise. Evaluate whether the potential setback to your retirement savings is worth the immediate access to funds.

FAQ About 401(k) Loans vs. Personal Loans

MoneyGeek addressed some frequently asked questions about 401(k) loans and personal loans to help you determine the best option for your unique situation.

Does a 401(k) loan affect your credit?

Can I get a loan from my 401(k) to pay off my debt?

Does a 401(k) loan count as income?

How much will I be taxed on a 401(k) loan?

Is it worth getting a personal loan to pay off debt?

Does it hurt to pay off a personal loan early?

How much does your credit score drop when you get a personal loan?

Which type of personal loan is easiest to get?

About Zachary Romeo, CBCA

Zachary Romeo, CBCA headshot

Zachary Romeo is a certified Commercial Banking and Credit Analyst (CBCA), and the Head of Loans and Banking at MoneyGeek. Previously, he led production teams for some of the largest online informational resources in higher education, with over 13 years of experience in editorial production.

Romeo has a bachelor's degree in biological engineering from Cornell University. He geeks out on minimizing personal debt and helping others do the same through people-first content.

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