Pros and Cons of Taking Out a 401(k) Loan

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October 02, 2023

Pros and Cons of Taking Out a 401(k) Loan

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There’s an assortment of reasons you may be considering a 401(k) loan, such as relief from drowning in high-interest credit card debt to experiencing a financial hardship you never saw coming. Whatever the reason, if you have access to a 401(k) retirement savings plan and you need funds, then you’ve likely wondered if a loan could be a viable option. There are some major benefits to taking on this kind of loan, but equally important, there are major drawbacks too — some of which you may never financially recover from. So before you head down this path, you will appreciate understanding both the pros and cons of taking out a 401(k) loan so you can make a sound decision.

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What is a 401(k) loan?

If you work for an employer, you likely have access to a 401(k) retirement savings plan (or if you’re a business owner and have established a self-employed 401(k) plan). A 401(k) loan is a financial arrangement where you can borrow money from your retirement savings account. It gives you access to a portion of the money you've saved for retirement, with the agreement to pay it back over time, typically with interest.

Like other types of loans, you pay interest on the amount you borrow, and your loan is subject to repayment terms and conditions. The IRS has rules around these types of loans too, requiring you to pay it back within five years or in some cases up to 25 years, with regular payments made at least once per quarter. You should also note these parameters only apply to a 401(k) loan and not another retirement savings account, such as a Roth IRA.

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Pros of using a 401(k) loan

There may be several advantages to borrowing against your retirement savings plan and getting access to the cash.

Avoid a loan application

When you borrow against the plan, you don’t have to fill out a lengthy application. This can be a huge advantage for anyone who doesn’t want to deal with a complex application process. Depending on the rules of your plan's administrator, you may not even have to give a reason for taking out the loan.

No credit check

Not only do you avoid a lengthy application process, you’re not subject to a credit check either. For anyone whose credit score has taken a hit or if you’re trying to avoid any inquiries on a credit report, this is another lifeline. Your credit score has no bearing on whether or not your loan gets approved.

Additionally, the plan administrator doesn’t report this type of loan to the three credit bureaus (Experian, Equifax, and TransUnion). Unlike other loans, if you fail to make a payment, it doesn’t appear on your credit report, although there are other consequences if you default.

No Prepayment or early withdrawal penalties

Some loans charge a penalty if you pay off a loan early, known as a prepayment penalty. However, with a 401(k) loan, there is no prepayment penalty. This means you can pay it off sooner if you can pay it back sooner.

Unlike using a hardship withdrawal, these loans are not subject to the 10 percent early withdrawal penalty either.

Lower borrowing cost

One of the main advantages of this loan is the lower interest rate the loan typically carries compared to traditional loans. The interest rate is generally one or two percent above prime, which is 8.50 percent as of September 25th. So paying 10.50 percent interest on a 401(k) loan may be lower than using a credit card or a personal loan rate, depending on what you would qualify for based on your creditworthiness.

Not only could you pay a lower interest rate, the interest you do pay goes back into your retirement account, versus lining the pockets of another financial institution.

Cons of using a 401(k) loan

While it may seem like an easy way to borrow money, taking out a 401(k) loan can have its drawbacks too.

The plan administrator must approve the loan

Even though it’s not based on creditworthiness, your loan must still go through an approval process from your plan’s administrator. Keep in mind some plans don’t even allow loans in the first place.

There are loan limits

The IRS has limits how much you can borrow from your plan. The limit is 50 percent of the account balance or $50,000, whichever is less. Your plan may approve an exception of 50 percent or more if your account balance is less than $10,000, but this exception is not a requirement by the IRS and is strictly up to the plan administrator.

Potential losses

Because you’re taking away from your balance, you have less money in investments, which means you are missing out on potential gains. You’ve taken out money that can grow over time and tax-free. Even when you pay yourself back, you won’t be able to make up for the time your money could have had in the market.

Tied to current employment

Another major caveat to borrowing from yourself is you can only borrow from your current employer’s plan and not from a former employer. However, you can roll your old balance into your current employer’s retirement plan and borrow from there.

Additionally, if you decide to leave your current employer and have taken out a loan, you must pay it back within a specific time frame (versus the standard five years). Failure to pay back means it’ll revert to a distribution, and you’ll face hefty taxes.

You may owe taxes and penalties

If you fail to pay back the loan for any reason (and not just leaving a job), it will be treated as a distribution. Distribution is subject to taxes and penalties.

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Alternatives to using a 401(k) loan

There may be other options worth considering for borrowing money. For starters, if you have savings, then now may be the best time to tap into your emergency savings. If you’re facing a financial hardship or dilemma, then this is exactly why you put emergency savings in place.

Another option could be a home equity loan or home equity line of credit (HELOC), where you borrow against any equity you’ve built as a homeowner. With a home equity loan, you can receive a lump sum and pay it back with interest. A HELOC acts like revolving credit and lets you borrow it as needed while paying it back with interest.

A personal loan is another loan option, and you can apply for these through almost any financial institution. Although these loans are subject to approval based on your creditworthiness, many can deposit funds within a business day or two and have flexible lending options.

FAQs

Is it better to cash out a 401(k) or take out a loan?

While everyone’s financial situation is different, and there are times when one option is a better fit than another, think carefully before taking out either a loan or distribution. With a loan, one of the main questions you should ask yourself is if you plan on staying with the employer for years and what is the financial impact of taking your money out of the market before paying it back.

How much are the fees on a 401(k) loan?

Confirming the fees charged before you take out a loan is a good idea. Some of the common fees include an origination fee and maintenance fees. An origination fee is typically a one-time charge, however, maintenance fees are often ongoing and paid regularly.

Will my employer know I’m taking out a 401(k) loan?

Your employer will know you’ve taken out a 401(k) loan. While it’s your money, your plan has certain rules and conditions around borrowing from it, which means you must work with your plan administrator to borrow within the parameters.

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If you're tight on cash right now, you may want to consider getting a personal loan. A personal loan is a loan that you can use for just about any purpose like: paying off other debt, renovating your home, or family needs like a wedding or adoption.
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Connect with lenders for $0
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The bottom line

There are numerous advantages and disadvantages worth weighing before deciding whether or not you should take out a 401(k) loan. While they’re ideal for those who want to avoid a credit check or someone looking for a more competitive interest rate, these loans are tied to your current employer, and it means you’re missing out on the benefit of time for growing your tax-free retirement savings.

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Sara Coleman is a former corporate gal turned creative entrepreneur. She began writing professionally several years ago and now contributes to multiple websites, blogs, and magazines. She’s also an avid reader and can’t resist a great historical fiction novel. Sara holds a BA in journalism from the University of Georgia and can be found supporting her Bulldogs every chance she has. She resides in Charlotte, North Carolina, with her wonderfully supportive husband and three children. When she’s not ushering her kids to sports and dance lessons, she can be found creating content for her own website, TheProperPen.com.

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