Sometimes life throws you a curveball, and due to mounting financial pressure over time or a sudden emergency, you may be in dire financial straits and looking for a solution. There are two very common and even popular ways to get loans to help with these situations, taking out a personal loan and taking a loan that borrows against your 401(k). Many people wonder just how personal loans and 401(k) loans work and if one is better than the other.
401(k) loans may be able to get you lower interest and more favorable terms overall, but the penalties on default can be more severe. On the other hand, a personal loan doesn't need any collateral, but it will have additional fees associated with them, even if they're paid off early.
There's a lot more to consider before taking any major steps toward borrowing, however. You'll need to consider what you'll be using the money for, how long you'll need it, and what you're willing to pay for it. You should also consider the overall impact on your retirement plan in the event that you end up defaulting on the loan. Let's take a closer look at just how both types of loans work and which one may be better suited to your needs.
A loan against your 401(k) is just what it sounds like; it is a loan that is taken out against your employer-sponsored 401(k) plan. The first thing to consider is whether or not you'll even be able to get a 401(k) loan, as not all employers or 401(k) providers allow loans to be taken out against the account. Those that do allow the loans will often have specific and numerous rules surrounding the funds available to be borrowed.
In most cases, the maximum you'll be able to borrow is up to 50% of your fully vested balance, or $50,000, whichever is less. Additionally, the maximum term of a 401(k) loan is 60 months or five years. This means that no matter how much you borrow, you'll need to finish the repayment within five years or less or risk the penalties associated with repayment failure. They will also accrue interest, just as any other loan will, though sometimes at a lower rate than conventional loans.
One of the reasons that people often borrow from their 401(k) is that the loans are incredibly versatile. They can be used for just about anything you need them for, including:
- Additional day-to-day expenses
- Entrepreneurial ventures or associated business startup costs
- Medical bills
- Fast cash for a home down payment
- Costs associated with home repairs, remodeling, or renovations
- Consolidation of high-interest debt
- Payment for educational expenses, either for yourself or a member of your immediate family
Should I Borrow From My 401(k)?
Many people feel that borrowing against their 401(k) is a smart option for paying down expensive, high-interest debt, but you will need to deeply explore the cost-benefit of this for your specific financial situation. The biggest drawback of taking out a 401(k) loan is that you immediately have a lower retirement portfolio balance. If you pay back the loan in time, you generally won't need to worry about penalties, but if you fail to pay it back in time, you'll pay an early withdrawal penalty of 10% on top of the tax penalty imposed on withdrawals prior to age 59 ½.
To determine if a 401(k) loan is going to be a good option for your needs, you'll need to look at the interest rate, the term of the loan repayment, and the total cost of the loan. If you look at your high-interest debt, such as credit cards and high-interest installment loans, you'll need to figure out how much extra that interest is costing you over that same term.
If you'll be paying more for the loan than the interest on those other balances, then a 401(k) loan isn't going to be a viable option for paying down that debt. You should also consider the average return heavily that you're earning with that money in your retirement fund. If you're going to significantly reduce the returns your 401(k) is generating by borrowing from it, that may also become a considerable offset of the loan value.
What Is A Personal Loan?
A personal loan is a loan that you borrow from a conventional lender that you can use for any personal expenses you determine worthy. Common sources of personal loans are traditional brick-and-mortar banks and credit unions, as well as online banks and specialized online personal loan lenders.
The most commonly-cited benefit of personal loans is that they are unsecured, meaning they don't require any collateral as security before origination. In rare cases, they may require an active checking or savings account in good standing, which essentially secures them with either savings or a certificate of deposit, which is often the case for "credit-builder" loans.
When comparing personal loans to 401(k) loans in the context of what you can use them for, there is little difference, if any. They can be used for the same purposes as 401(k) loans, including paying off medical bills, consolidation, and payment of high-interest loans or lines of credit, large purchases, or even home remodeling. Personal loans are most often used for debt consolidation since they allow the borrower to pay off multiple credit cards or installment loans, stopping interest accrual and reducing their obligations to a single monthly payment to a single source.
While there is often little needed for a 401(k) loan in terms of qualification, a personal loan will often require a formal application. This application will generally require you to specify how much you intend to borrow, as well as personal information. A personal loan will require a hard credit pull, which can affect your credit score. Your approval will depend greatly on your overall creditworthiness, income, and the acceptance requirements of the lender you're applying to.
The credit score requirements for a personal loan will vary greatly by the lender. While there are no universal minimums, the most common "low-end" credit score cutoff is 640 on the FICO scale. You may be able to find personal loans with more relaxed acceptance, but they will generally make it up with higher interest and less favorable terms. On the other hand, the higher your score, the more favorable your loan terms and associated interest rates will be.
Cashing Out 401(k) vs. Personal Loan
Cashing out a 401(k) is almost never a good idea, and it's almost always a worse financial decision than any other option. When you cash out your 401(k), you are essentially taking what's called a "hardship withdrawal," which generally consists of closing your 401(k) and taking all available funds out. This is a bad idea for a number of reasons.
First of all, if you're younger than 50 ½, you'll pay a significant early withdrawal penalty. On top of this penalty, which is frequently around 10%, you'll also be subject to a significant tax penalty that will further reduce the funds you eventually get. Finally, you'll be eliminating any chance of future gains and retirement security from that account. In almost any situation, a personal loan will be a better option.
Personal Loan vs. 401(k) Withdrawal
While many people may not need to cash out their 401(k) fully, they may be considering taking a withdrawal. These partial withdrawals will be subject to the same early withdrawal penalties as a hardship withdrawal, but they will only be available for a portion of the overall 401(k) account balance.
Those that choose to utilize a partial withdrawal will not have to worry about fully closing their 401(k) account, nor will they need to worry about repaying the funds as would be required with a 401(k) loan. However, they will be restricted as to how much they can withdraw before penalties are applied. Additionally, when tax time comes around, you'll be taxed on the disbursements you've taken from your 401(k), which are taxed heavily for those below retirement age.
In cases like these, whether a personal loan will be better than a partial withdrawal will generally depend on a few things. It will depend on the terms of the potential loan, as well as the performance of the 401(k) and the amount you are permitted to withdraw before penalties. There are some situations where a withdrawal may be more prudent and affordable than a personal loan, but they are relatively rare.
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Understanding How Personal Loans & 401(k) Loans Work Can Better Prepare You For Retirement
If you need a cash infusion to help you get by, or if you need a larger amount to help you make a big purchase, the best practice is to figure out all of the total costs for your lending options ahead of time. Know what your interest rates are going to be, whether they'll save or cost you money, and what your potential penalties will be. Then you'll know if you are making a sound borrowing decision or putting your retirement at risk.
Shawn Manaher is a former financial advisor, has founded 5 online businesses, and is a coach, speaker, podcast host, and author. He's been featured on The Consults Corner on TAE Radio, The Writing Biz, What's Your Story, and more.