Personal Loans vs. 401(k) Loans: Which Is Best For You?

Article Summary:

There are multiple pros and cons to consider when comparing personal loans vs. 401(k) loans. 401(k) loans typically provide the cheapest option and are easier to qualify for. They are, after all, a loan you pay back to yourself — with interest. However, there is an opportunity cost to keep in mind because you miss out on tax-deferred investment earnings. Also, if you lose your job, you may have to repay a 401(k) loan much faster than anticipated. Personal loans have higher interest rates and fees, but they offer flexibility. Additionally, the loan amounts and payment terms are not dependent on your 401(k) balance or whether you stay with your employer.

So you need to borrow money and you either can’t or don’t want to use your home equity (mortgage refinance, HELOC, or shared equity) as a financing option. That means the next best options for borrowing money are probably personal loans and 401 k loans. Whether for income taxes, an unexpected expense, a hardship withdrawal, or education expenses, both 401(k) loans and personal loans could be a good fit for you.

We are going to compare them both in detail to help you decide which is best for you.

Personal loans vs. 401(k) pros and cons

WEIGH THE RISKS AND BENEFITS

Compare the features of A and B before you make a decision.

Personal loans
  • Potentially faster access to funds.
  • You may qualify for higher loan amounts.
  • No collateral is lost if you don’t pay.
  • No dealing with arbitrary rules from plan administrators.
  • Doesn’t matter where you work or your plan’s rules or if you change jobs.
  • You don’t put your retirement funds at risk.
401(k) loans
  • Lower interest rates and the “interest” is paid back into your retirement account.
  • You may have to pay taxes and penalties on the loan if you don’t repay it in time.
  • You avoid the taxes and penalties of an early withdrawal.
  • The maximum loan amount is 50% of your vested 401(k) balance or $50K, whichever is lower.
  • Most (about 8 out 10) but not all 401(k) plans offer loans.
  • You’ll have to pay it back sooner if you change jobs.
  • Do not require a credit check
  • Up to 5-year term but possibly longer if for your principal residence

Let’s dig a little deeper into the pros and cons of personal loans vs. 401(k)s.

Benefits and disadvantages of personal loans

Personal loans go by several names, such as installment loans or marketplace loans. Personal loan lenders have been very aggressive in adding new loans to their books. There’s a whole ecosystem of these lenders that cater to excellent credit down to poor credit. Here are the main pros and cons to consider with personal loans.

WEIGH THE RISKS AND BENEFITS

Here is a list of the benefits and the drawbacks to consider.

Pros
  • It’s an installment loan, which can help with your credit score if you pay on time.
  • No collateral is lost if you don’t pay
  • No dealing with arbitrary rules from plan administrators
  • Doesn’t matter where you work or your plan’s rules or if you change jobs
Cons
  • It’s an installment loan, and that is better for your credit report and score
  • No collateral is lost if you don’t pay
  • No dealing with arbitrary rules from plan administrators
  • Doesn’t matter where you work or your plan’s rules or if you change jobs

Personal loans have the potential to help (or damage) your credit score

Most of us have loans and credit in two categories with the 3 main credit bureaus: Installment and Revolving credit. Revolving credit is credit cards and other credit usage that once you pay it back that amount becomes available to borrow again. An installment loan is a loan with a fixed payment for a fixed period of time like a mortgage or a car loan. Both are important in calculating your credit score but installment debt is a higher quality debt. It’s good to have a mix of both types of debt.

No collateral is lost if you don’t pay

Personal loans have no collateral so if you cannot pay, you do not end up with a lien on your home or liquidation of part of your retirement plan. Your credit will suffer but you won’t lose any of your other assets.

No dealing with arbitrary rules of plan administrators

It says it right here on the IRS website, a qualified plan may but is not required to provide for loans. The plan can limit the amount you can borrow even more than the $50,000 or 50% vested account balance, whichever is smaller that is the current tax law.

Doesn’t matter where you work or your plan’s rules or if you change jobs

With a 401 k loan, you have to pay back your total outstanding balance if you change jobs or leave the job where your current plan is. And if you don’t pay it back, then it’s considered a distribution and taxable to you. Your plan’s rules will let you know how long you have to pay it back before it becomes part of your income for this tax year.

And now the disadvantages in more detail.

Higher Origination Cost

Loan origination costs for a personal loan can go as high as 4-5%. That can get into a lot of money. On a $40,000 loan, 5% is $2000. Origination fees are much lower, often under $150 for a 401(k) loan.

Higher Interest Rates

Interest rates at personal loan lenders can vary wildly from single digits to high interest debt. You’ll know before you sign the papers what your interest rate and monthly payment is but it will be higher than a loan on your employer’s plan. Those are often quoted based on the Prime Lending Rate. Today, that’s 3.25% so Prime +1 would be a 4.25% interest rate. That’s a lot less money than a personal loan interest rate.

Interest payment doesn’t go back into your investment account, it goes to the personal loan lender

With a personal loan, the lender makes the loan, charges compounding interest, and keeps the interest as their revenue. But with a 401 k loan, when you pay interest based on the loan terms, that money goes back into your own account. It’s like the left hand paying the right hand. It’s your money.

You may not have the credit to qualify

Personal loans have the added challenge of having to meet credit eligibility requirements. So you may be approved and you may not.

Borrowing Against Your 401(k)

Cash crunches are no joke. If you need money fast, it can be tempting to take out a loan from your 401(k), particularly if several lenders have turned you down. There is no denying that borrowing against your 401(k) has some unique advantages. Here’s a look at the main pros and cons of 401(k)s.

WEIGH THE RISKS AND BENEFITS

Here is a list of the benefits and the drawbacks to consider.

Pros
  • Speed and convenience
  • Repayment flexibility
  • Better than early withdrawals with a 10% penalty
  • Lower interest rates
  • No credit check
  • Up to 5-year term but possibly longer if for your principal residencePay back less than what you owe
Cons
  • You may not be able to get one based on your plan.
  • The maximum you can borrow is $50,000 or 50% of vested whichever is less.
  • Negative impact on your investment performance.
  • Your unpaid balance will become taxable income.
  • Only current 401 k can be used, not old ones.
  • Have to pay back faster than the agreed term if you leave your job.
  • Not reported to the 3 credit bureaus

Not surprisingly, 401(k) loans are quite popular. A study by the Pension Research Council revealed that 20% of loan-eligible 401(k) plan holders had an outstanding loan at the time of the study. However, 401(k) loans have some important disadvantages to consider. Typically, we should only consider as a last resort.

Speed and convenience

While approval for a personal loan is fast, if your 401 k plan allows for loans, then you are automatically approved as a member of the plan. And you never have to show more documentation like proof of income because the loan is coming from your own retirement account.

Repayment flexibility

A 401 k loan does not charge prepayment penalties if you pay off the loan early. The loan is amortized up to 5 years but you can pay back more or pay back early. You can also pay through a payroll deduction since your plan is connected through the company. You are paying the loan back with after-tax dollars.

Better than early withdrawals with a 10% penalty

A hardship withdrawal is when you need money right away. Medical expenses or home repairs qualify. When you ask for one, you are taking a distribution as an early withdrawal. Typically, you will need to pay the 10% penalty if you are under retirement age, but you won’t have to pay it back. You are paying the tax penalty on that money also since you used pre-tax money or an employer contribution to grow the account.

You avoid having to pay taxes and penalties if you decide to take a loan against your 401 k instead. Given the choice, a loan is always better than a withdrawal if you are not old enough to take distributions yet. Withdrawals should be a last resort.

Lower interest rates

As we mentioned above, interest rates are much lower for 401 k loans than a personal loan. Even the best credits for personal loans pay around 8% or 9%, meaning your interest rate might be double or more than your interest rate on your 401 k loan. Your loan payments will be much lower with a 401 k loan.

No credit check

Unlike a personal loan, there are no credit checks. Your 401 k loan is based on your account and the rules of your employer’s plan.

Up to 5-year loan term but possibly longer if for your principal residence

One added benefit is that you can borrow money for more than five years if you are using the money as a down payment on your own personal residence. However, your plan administrator has to approve it.

And now the disadvantages in more detail.

You may not be able to get one based on your 401 k plan

Your plan may not allow you to borrow against your retirement savings and it’s up to the plan administrator to decide.

The maximum you can borrow is $50,000 or 50% of vested balance whichever is less

This $50,000 loan limit is the same as with a personal loan. However, the IRS guidelines say that if 50% of your vested account balance is less than $50,000, then the loan limits are the lesser of the two.

Only current 401 k can be used, not old ones

If you have left old 401 k accounts with old employers, then you cannot borrow against them. Only your current 401 k account can be used. If you’ve down a rollover of the assets into the new plan, then you can borrow against them.

Have to pay back faster than the agreed term if you leave your job

Loan terms are up to five years but if you leave your job for any reason, you will have to pay it back sooner. Plans differ on how long you have to pay it back before your non-payment is considered a withdrawal with tax consequences. This is a question you should know the answer to before you borrow from your 401 k.

Not reported to the 3 main credit bureaus

A 401k loan is not considered a debt. The 3 main credit bureaus do not know you are borrowing against it because there was no credit check. No one reports your loan repayments either. Your credit score is unaffected.

Some will see this as a positive, and others who will pay back on time see it as a negative. Your credit history remains the same as if you did not take the loan.

Key takeaways

  • Both personal loans and a 401 k loan have advantages for when you need to borrow money
  • Both loans are paid with after-tax dollars even the one to your retirement plan.
  • Personal loans are credit-based and don’t affect your retirement account balance.
  • Getting a personal loan does not put any other assets at risk.
  • Personal loans report your interest payments so you can improve your credit score
  • 401 k loans have excellent loan terms as you are borrowing your own money
  • Not all 401 k plans allow you to borrow
  • 401 k loans are fast, easy, and cheap. There is no credit check.
  • A 401 k loan is much better than a hardship withdrawal or other early withdrawal
  • 401 k loan terms change if you leave your job for any reason or it’s considered an early withdrawal and taxable to you.
Article Sources
  1. Borrowing from the Future – Pension Research Council
  2. Withdrawing Money from your 401 k– Supermoney
  3. Using Your 401 k to Pay Off Your Credit Cards– Supermoney
  4. Best Personal Loans – Supermoney
  5. Industry Study on the Personal Loan Industry– Supermoney
  6. How to Qualify for a Personal Loan– Supermoney
  7. Taking a Loan to Pay Taxes? Here’s What You Need to Know– Supermoney
  8. Are Home Improvement Loans Tax Deductible?– Supermoney
  9. Hardships and Early Withdrawals from 401 k Plans– IRS
  10. FAQ on Taking a Loan from your Retirement Plan– IRS