What is a 401(k) loan?
While, in principle, a 401(k) loan can be seen as borrowing your own money, it’s important to know how these loans work. Here’s everything you need to know.
What is a 401(k) loan?
A 401(k) loan is when you borrow a portion of the savings in your 401(k) account. When you decide to take a loan out of your 401(k) account, you are simply borrowing money that has been invested through an investment account.
Taking out one of these loans could be a good decision if you're in a financial emergency. You will only need to pay yourself back, with only a little interest to repay. For this reason, taking out a 401(k) loan can be a quicker and simpler alternative to taking out a loan from a bank.
However, borrowing from your 401(k) account means taking money out of an investment pot that grows over time. Without your money generating compound interest, you could miss out on important retirement money.
How does a 401(k) loan work?
If you want to take out a 401(k) loan, you must first determine if your plan allows you to borrow part of your funds. To find out if your plan is eligible and request a 401(k) loan, you will need to contact your 401(k) administrator. Once your loan has been approved, some of your 401(k) investments will be sold, and you will receive the money.
But while borrowing from your investment account, there are limits on what you can take out as a loan. The IRS only allows you to withdraw up to $50,000, or 50% of the assets in your account, depending on which is less.
As part of your loan agreement, you must make scheduled repayments, usually quarterly. Anything you borrow must be repaid within five years unless you plan to buy a property.
Should I take out a 401(k) loan?
With little interest to pay, a 401(k) loan could be a good option if you need to find cash quickly and have enough 401(k) funds to cover it. You won’t need a credit check to take out a loan, and it won’t appear on your credit history – even if you default. Additionally, thanks to their usually quick approval, opting for a 401(k) loan could be the fastest and easiest way of securing a short-term loan.
But while a 401(k) loan could be a good option for short-term borrowing, they are much less suitable for the long term.
When it comes to borrowing money, ask yourself whether you need a short or long-term solution, as a 401(k) loan may not be the right option. You should also remember that taking money out of your retirement savings means missing out on interest payments and any market growth from which your investments could benefit.
What are the pros and cons of a 401(k) loan?
To help you decide whether taking out a 401(k) loan is the right option for you, let’s take a closer look at the benefits and drawbacks of these loans.
Among the advantages of a 401(k) loan are:
Speed of approval: Taking out a 401(k) loan can be done easily. You will often have your money in a few days, making a 401(k) loan a good option if you need to act quickly.
Repayment flexibility: A 401(k) loan can be repaid early with no repayment fees. As soon as you’ve taken out your loan, you can start paying it back faster than your scheduled repayments.
Low costs: As you’re borrowing money from one of your own savings accounts, you’re effectively moving money from one place to the next. There are no early withdrawal fees; any interest you pay on your loan will return to your account.
Adding to your savings: As you make your loan repayments back into your 401(k) account, they will usually be allocated back into the original investments that were made. Including the small interest that you have repaid, you will be putting a small amount more back into your original investments, which can help grow your savings.
However, 401(k) loans do have some drawbacks too, and you should remember that:
Withdrawing funds can slow the growth of your savings: When you borrow from your 401(k), the funds you withdraw will no longer earn compound interest or grow with the market. This could mean missing out on substantial growth.
You could be double taxed: Your 401(k) loan repayments are made with after-tax dollars. However, when you eventually withdraw these funds in retirement, they will be taxed again as income.
Late repayment: If you can’t repay your full loan, you can incur late payment fees and penalties.
Early repayment: If your circumstances change, such as losing your job, your repayment schedule can be accelerated, meaning you may need to repay the full balance much sooner than planned.
Taking out a 401(k) loan
While these are all factors to bear in mind, it's best to seek professional financial advice when considering a 401(k) loan. You can start by taking our five-minute survey and get matched with a financial advisor suited to meet your exact needs in as little as 48 hours. Get started here.
What are some alternatives to 401(k) loans?
Borrowing money from your 401(k) is one way of raising cash. But there may be better alternatives. Before taking out your loan, consider some of the following options.
Emergency savings
It’s always a good idea to have three months’ worth of savings in case of an emergency. Using these funds means you can keep your 401(k) topped up and accumulating instead of missing out on this growth.
Personal loans
You could take out a personal loan, which you would repay over time. Personal loans have a fixed interest rate and can be approved quickly. Instead of borrowing your 401(k) funds, a personal loan allows you to borrow and repay quickly without missing out on any investment growth.
The bottom line
A 401(k) loan is an easy way of borrowing money from your own investment account and using it for other reasons. While it doesn’t operate like a normal loan, there can be repercussions if you can’t repay it on time. Taking money out of your 401(k) can also leave you worse off over the long term. Moreover, there may be quicker alternatives that don’t leave your retirement funds worse off.
A financial advisor can help you with your financial planning. Find one today with Unbiased.
Senior Content Writer
Rachel is a Senior Content Writer at Unbiased. She has nearly a decade of experience writing and producing content across a range of different sectors.