401(k) loans: What they are & how they work
401(k) loans: What they are & how they work
401(k) loans: What they are & how they work
When you need to borrow money, a 401(k) loan is one of your options. A 401(k) loan allows you to borrow from the balance you’ve built up in your retirement account. There are some key advantages of 401(k) loans over other alternatives, but 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?
If you’ve spent any time in corporate America, then you probably know what a 401(k) is: an employer-sponsored retirement plan that allows both employees and their employers to contribute toward their retirement.
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 Empower research reveals that new loans amount to $10,778 on average, with more than half of outstanding loans (54%) held by Gen Xers.
A 401(k) 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. The approval process is very different from getting a loan from a third-party lender. For example, there’s no credit check required to qualify, nor do you have to meet certain debt-to-income ratio requirements. Instead, you contact your 401(k) plan administrator and let them know that you’d like to take out a loan, along with how much you’d like to borrow.
When taking a 401(k) loan, you can generally borrow the lesser of 50% of your vested balance or $50,000.
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. Any employer contributions that aren’t fully vested aren’t considered a part of your 401(k) balance eligible for a loan.
While some plans may allow you to take out more than one loan from your 401(k) at a time, if you do, the amount you can borrow will be reduced. 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.
401(k) loans must be repaid within five years unless your plan offers primary residence loans, in which case you have longer to pay it off. You must repay your loan in substantially level payments, which must be made at least quarterly. For example, depending on what your plan allows, you could decide to make payments quarterly, monthly, biweekly, or even weekly.
Regulations from the Department of Labor require 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 the prime rate, meaning the rate that banks and credit unions charge the most creditworthy borrowers.
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, for example. Additionally, because you’re also the lender on the loan, the interest you pay goes back into your 401(k) balance.
Leaving your job
As we mentioned, you must repay a 401(k) loan within five years. However, that can change if you leave your job before repaying your loan. Many plans require that you repay the full loan amount immediately. Even if you don’t plan on leaving your job anytime soon, this requirement applies regardless of whether you leave your job or your employer lets you go.
If you fail to repay your loan on time, including any required interest, then the unpaid amount is considered an early distribution. The money will be treated as any other early distribution, meaning you’ll pay both income taxes and if you’re under 59 ½, a 10% early withdrawal penalty if applicable.
The opportunity cost of borrowing from your 401(k)
It’s impossible to talk about 401(k) loans without talking about their significant opportunity cost. Opportunity cost refers to the loss associated with the option you didn’t choose. In this case, it 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 is able to potentially 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 is a better alternative to a withdrawal since it allows you to avoid income taxes and penalties, as well as eventually replenish your balance.
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: If you leave your job, whether by your choice or your employer’s, you may have to repay your full loan balance right away.
- 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 experts 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 another type of loan. While it’s typically better to consider personal loans and other alternatives before 401(k) loans, other loans have credit requirements.
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.
Of course, 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 go into this loan with 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 accomplishes two things:
- Allows you to repay your loan on time or early
- 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:
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.
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.
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.4
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.
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.
Unfortunately, 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.
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, experts generally recommend between three and six months of expenses.
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 your 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 money that’s already yours 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.
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- IRS, “401(k) Resource Guide - Plan Participants - General Distribution Rules,” December 2023.
- GovInfo, “Employee Benefits Security Admin., Labor,” accessed December 2023.
- Consumer Finance Protection Bureau. “What is a personal installment loan?” December 2021.
- Federal Trade Commission. “Home Equity Loans and Home Equity Lines of Credit,” December 2021.
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