Key takeaways:

• 401(k) loans are typically capped at the lesser of 50% of vested balance or $50,000, if your plan allows loans.
• You generally must repay within five years (longer if used to buy a principal residence), with level payments at least quarterly.
• If you leave a job, an unpaid loan may be offset and subject to taxation — but you typically have until your tax return due date (including extensions) to roll it over and avoid taxes.

A 401(k) loan taps your retirement savings and is repaid at a “reasonable” plan-set interest rate. The tradeoffs: lost market growth, repayment risk if you change jobs, and potential taxes/penalties if you default. You may want to consider other lower-cost alternatives before borrowing from retirement. 

When you need to borrow money, a 401(k) loan may be one of your options. A 401(k) loan allows you to borrow from the balance you’ve built up in your retirement account. While 401(k) loans have some key advantages, these loans may not be advisable unless you’ve exhausted your other options. They can be costly for your future and come with risks that are often overlooked.

What is a 401(k) loan?

A 401(k) loan is a tool that allows you to borrow from the balance you’ve built up in your retirement account. Generally, if allowed by the plan, you may borrow up to 50% of your vested balance, for a maximum loan amount of $50,000.¹ (Loan caps are set by federal law; plans may impose stricter limits or disallow loans entirely.)

This loan is different from other types of loans in that you are both the lender and the borrower. The good news is it makes these loans easier to qualify for than many others. However, it also means you’re the only one at risk if you don’t repay the loan in a timely manner.

Read more: What is a 401(k)?

How do 401(k) loans work?

401(k) plans aren’t required to allow loans, but if a plan does offer one, anyone can take one out if you meet plan requirements. Unlike other loans, there’s no credit checks or debt-to-income ratio requirements. A borrower contacts the 401(k) plan administrator to take out a loan and specify the amount. Plans must follow written loan procedures (availability, security, and a reasonable interest rate) and apply them consistently.

Borrowing limits

When taking a 401(k) loan, you can generally borrow the lesser of 50% of your vested balance up to $50,000. IRS rules applicable to  multiple loans within a 12-month period can reduce what you’re allowed to borrow.

Vesting refers to the process of how you gain ownership of your employer contributions in your account. While your employee contributions are always 100% vested immediately, some employers have a vesting schedule where matching or profit-sharing contributions take a certain number of years to vest. Employer contributions that aren’t fully vested aren’t eligible for a loan.

Some 401(k) plans may allow you to take out more than one loan, under the applicable borrowing limits. For example, if you already have a loan for $10,000 and wish to take another, then your maximum loan amount on the second loan is $40,000.

Loan repayment

401(k) loans must be repaid within five years, unless the plan allows for longer repayment periods if you use the loan for a down payment on a primary residence. You must repay your 401(k) loan in substantially level payments, at least quarterly. For example, depending on what your plan allows, you could decide to make payments quarterly, monthly, biweekly, or even weekly.

Loan interest

The Department of Labor requires that 401(k) plan loans “bear a reasonable rate of interest.”² While there’s no set interest rate that plans must charge, the rate used is often based on the prime rate, meaning the rate that banks and credit unions charge the most creditworthy borrowers. Interest you pay is credited back to your account.

The interest on a 401(k) loan increases the amount you must repay. However, it may work out in the borrower’s favor overall.

First, the interest rate on 401(k) loans is often lower than the rate the same borrower could get on a personal loan. Additionally, because you’re also the lender on the loan, the interest you pay goes back into your 401(k) balance.

Leaving your job

The five-year repayment requirement can change if you leave your job before repaying your loan. Many plans require that you repay the full loan amount immediately. This requirement applies regardless of whether you leave your job voluntarily or your employer lets you go. If your plan offsets the unpaid balance, you generally have until the due date of your federal tax return for that year (including extensions) to roll over the “qualified plan loan offset” amount and avoid current taxes and potential penalties.

Unpaid loans

If you fail to repay your loan on time, the unpaid amount and required interest is considered an early distribution. The money will be treated as any other early distribution, meaning you’ll pay income taxes. If you’re under age 59½, a 10% early withdrawal penalty could apply. Plans also treat missed payments as a “deemed distribution,” which is taxable even though the loan balance may still be owed to the plan.

The opportunity cost of borrowing from your 401(k)

It’s impossible to talk about 401(k) loans without considering opportunity cost — the loss associated with the option you didn’t choose. In this case, opportunity cost refers to what you lose out on by taking a loan from your 401(k) rather than leaving the money in the account.

When your money is in your 401(k), it’s invested and can grow and compound. The more you have in your account — and the longer it's there — the more you may have for retirement.

By taking out a large sum from your 401(k) for up to five years, you’re missing out on potential gains you might have earned if you’d left the money in the account.

Another potential opportunity cost associated with a 401(k) loan is that of the contributions you may not be able to make while repaying your loan. Suppose you normally contribute $500 per month to your 401(k). But now you pay $250 per month toward your 401(k) loan, meaning you only have $250 left over for regular contributions.

During the five years it takes you to repay your loan, you’re cutting your contributions in half, meaning you may end up saving significantly less for retirement. This could make the difference of tens of thousands of dollars during retirement.

Pros of taking a 401(k) loan

There are several advantages of 401(k) loans, which make them worth considering for many borrowers:

• Lower interest rates: 401(k) loans may have lower interest rates than the average borrower would be able to get on a personal loan or a credit card.
• Interest payments benefit you: In addition to the low interest rate, any interest you pay on your 401(k) loan goes directly into your account and contributes to your retirement account balance.
• No credit check or impact on credit score: Unlike other types of loans, there’s no credit check required for a 401(k) loan, nor does getting the loan affect your credit score.
• Avoid penalties: A 401(k) loan can be a better alternative to a withdrawal since it allows you to avoid income taxes and penalties, as well as eventually replenish your balance. (Defaulting on a loan can still trigger taxes and, if under age 59½, the 10% penalty.)

Cons of taking a 401(k) loan

Despite the benefits of a 401(k) loan compared to other types of loans, there are also some significant downsides:

• Impact on retirement savings: A 401(k) loan reduces your investment earning potential, which may reduce the amount of money you have for retirement.
• Repayment upon leaving your job: You may have to repay your full loan balance right away if you leave your job whether by your choice or your employer’s. If repayment isn’t possible, understand your rollover window for a loan offset to limit taxes.

Read more: What to do with your 401(k) when you leave your job

• Early withdrawal risks: If you can’t repay your loan, it will be considered a withdrawal and subject to income taxes and early withdrawal penalties if you are under age 59 1/2.
• Potential for reduced contributions: Depending on your monthly budget, repaying your 401(k) loan may limit the amount you’re able to make in new contributions.
• Strict loan limits: 401(k) loans are limited to 50% of your vested balance or $50,000, which may be less than you could borrow elsewhere.
• Not always available: Retirement plans are not required to allow participants to take loans, meaning you may not even be eligible for one.

When to consider a 401(k) loan

In many cases, the downsides of 401(k) loans may outweigh the benefits and, for that reason, many financial professionals recommend against them. However, there are some situations where a 401(k) loan might make sense and be your best option.

First, a 401(k) loan might be worth considering if you’re in a financial emergency and your credit doesn’t allow you to qualify for a personal loan or other alternatives.

In some cases, a 401(k) loan may be your only option short of a payday loan or an early distribution from your retirement account. And in those cases, it’s likely better to go with the 401(k) loan.

There are also factors to consider. For example, you should only consider a 401(k) loan if you feel your job is secure. If you lose your job during your loan repayment, you could be forced to repay the entire balance or have it count as an early distribution.

Repaying a 401(k) loan

If you’ve taken out a 401(k) loan, you’ll have five years to pay it back in most cases. And if you don’t repay it on time, you’ll be stuck paying income taxes and penalties on an early distribution if you are under age 59 1/2.

Because of the potential consequences of not repaying your 401(k) loan on time, it’s important to have a plan. Take a look at your personal finances and determine how quickly you can pay off the loan. Determine the frequency of payments — weekly, biweekly, monthly, or quarterly — and how much you can pay each time.

Ideally, you should aim for a repayment plan that: 

1. Allows you to repay your loan on time or early
2. Allows you to continue making regular contributions to your 401(k)

Finally, consider how you’ll handle a situation where you leave your job (or are forced to leave) and must repay the full balance right away. Do you have sufficient savings to repay the loan, or will you be forced to take an early distribution? Though you may not be planning to leave your job, it’s best to have a plan just in case.

Alternatives to 401(k) loans

As we’ve mentioned, a 401(k) loan may not be the best option in many situations. Instead, here are some alternatives to consider:

Personal loans

A personal loan is a type of unsecured loan that can be used for just about anything. Personal loans have fixed interest rates and fixed monthly payments. Depending on your credit, you may be able to borrow up to $100,000 and pay it off over a term of up to seven years.³

Personal loan interest rates are primarily based on your creditworthiness. They tend to have higher interest rates than most 401(k) loans and secured loans. However, they are a more affordable alternative to most credit cards.

Because personal loans can be used for just about anything, they are a popular borrowing tool. Many people turn to them for debt consolidation, financial emergencies, and even large purchases. Consider comparing APRs and fees across different lenders; required disclosures help you spot total cost.

Home equity loans and lines of credit

Home equity loans and home equity lines of credit (HELOCs) are two ways of borrowing against the equity you have in your home. These loans are often called second mortgages because they are secured by your home, just like your mortgage is.⁴

A home equity loan is an installment loan with a fixed interest rate, similar to a personal loan. A HELOC, on the other hand, is a type of revolving credit, meaning it works more like a credit card where you can borrow from it again and again as long as you repay it.

Because home equity loans and HELOCs are secured by your home, they tend to have relatively lower interest rates. The amount you can borrow depends on how much home equity you have. Lenders generally require a combined loan-to-value ratio of 80% or less when taking out a home equity loan.⁵

Home equity loans and HELOCs have some key benefits, including their flexibility and lower interest rates. However, the key risk with these loans is that if you fail to repay them, you could have your home foreclosed on. Consider shopping for multiple offers and read HELOC disclosures; using your home as collateral can add additional risk.

0% APR balance transfer credit card

If you need a loan to pay off credit card debt, consider a balance transfer card. Some credit cards allow you to pay 0% on balance transfers for a certain period — often anywhere from six months to two years. As long as you repay the balance in that time, you won’t pay any interest.

You usually need good or excellent credit to qualify for a balance transfer credit card. Additionally, if you can’t repay the balance within the 0% introductory period, then you’ll pay the full interest rate, which is typically far higher than other types of loans. Some credit card providers may also charge a transfer fee.  

Emergency fund

In some cases, a financial emergency sneaks up on you before you’ve had a chance to build up your emergency savings. However, in a perfect world, you would already have an emergency fund in place when an unplanned expense comes up.

If you don’t already have an emergency fund, now is the time to start building one before you need a loan. While there’s no magic number to have in your emergency fund, financial professionals generally recommend between three and six months of expenses. Investing this in a high-yield, FDIC-insured account helps keep it liquid and lowers risk.

Read more: The real cost of loans

Debt relief options

If you’re struggling with lots of debt and can’t pay it off through monthly payments, consider other debt relief options. There are companies and nonprofit organizations that help consumers manage their debt burden.

Your first debt relief option is debt settlement. This process often allows you to settle your debt for less than you owe. However, it can be expensive and often ends up having detrimental consequences for your credit.

Another type of debt relief is a debt management plan. In this case, a credit counseling organization helps create a debt repayment plan by speaking with your creditors and coming up with a monthly amount you can afford.

Proceed with caution when shopping around for debt relief options. The debt relief industry can be a breeding ground for scams, so it’s important to make sure you’re working with a reputable company.

Bankruptcy as a last resort

Bankruptcy is a legal process that can help consumers either discard their debt or make a plan to pay it off. In some cases, bankruptcy can help relieve a debt burden by liquidating someone’s assets and discarding their remaining debt.

While bankruptcy may seem attractive at times, it should be used as a last resort due to the significant long-term impacts it has on your credit and personal finances. Depending on the situation, a 401(k) loan is often preferable to bankruptcy.

Will your employer know?

You may be concerned about your employer knowing if you’re taking out a 401(k) loan. After all, personal finances are just that — personal — and you may not want colleagues knowing you had to borrow money from your retirement plan.

In most cases, your employer is also the plan administrator and will know that you’ve taken out a 401(k) loan. You must often go through your human resources department to arrange the loan and repayment through payroll.

The bottom line

A 401(k) loan allows you to temporarily access your retirement money to cover any number of financial obligations. 401(k) loans have some key advantages and disadvantages.

If you’re facing financial hardship and are considering a 401(k) loan, make sure you look at your other options first. You may find something else that works better for your situation. And if it turns out a 401(k) loan is your best option, make sure you thoroughly understand what you’re getting yourself into and that you have a plan to repay your loan as quickly as possible.

FAQ

1. How much can I borrow from a 401(k) loan?

You can typically borrow up to the lesser of 50% of your vested account balance or $50,000, if your plan allows loans. Plans may set stricter limits or disallow loans.  

2. How long do I have to repay a 401(k) loan?

Repayment is typically required within five years, with substantially level payments at least quarterly. A longer term may be allowed if the loan is used to buy a primary residence.  

3. What happens if I leave my job with a 401(k) loan?

Unpaid balances may be offset and taxed by your plan. You generally have until your federal tax return due date (including extensions) to roll over the offset amount and avoid current taxes and possible penalties.  

4. Does taking a 401(k) loan affect my credit score?

No. 401(k) loans do not involve credit checks and are not reported to credit bureaus, so they do not impact your credit score.  

5. Is the interest on a 401(k) loan a cost or a benefit?

The interest you pay goes back into your own account, but borrowing reduces potential market growth and may limit new contributions while you repay.  

6. What happens if I miss a 401(k) loan payment?

Missed payments can trigger a “deemed distribution.” The outstanding loan balance becomes taxable, and if you’re under 59½, a 10% penalty may apply.

7. Are 401(k) loans always available?

No. Employers are not required to offer plan loans, and some plans prohibit them altogether.