September 6, 2024

Considering a 401(k) Loan? What to Know Before Borrowing

A 401(k) is the beating heart of retirement preparation. Through a combination of tax-deferred growth and corporate contribution matching, this account type lets you save money and strategically grow it through investing — all to create a nest egg to pull from during your golden years. But did you know you can borrow from your 401(k)?

Ideally, you let your 401(k) grow until you’re ready to retire. But life throws curveballs, and sometimes, that money is your only option. That’s where 401(k) loans come in.

These loans offer a flexible way to borrow money without the tax implications of withdrawing it directly. Since everyone's financial situation is unique, it’s important to consider the pros and cons of taking out a 401(k) loan and decide if it’s right for you.

Here’s a guide to how a 401(k) loan works, how much you can borrow from it, and if it affects your credit.

What’s a 401(k) loan, and how does it work?

There are two ways to access your 401(k): borrowing and withdrawing from it.

When you think about using your 401(k), you probably think of withdrawing from it. This refers to permanently removing that money from the account. If you do so before you’re 60, you might have to pay fees or penalties.

But with a 401(k) loan, you can borrow from your retirement savings without fees or penalties — as long as you pay the money back. Any interest you pay goes back to your retirement account instead of to a traditional lender, helping you compensate for any growth you lost while using the money.

The plan or account's administrator sets the specifics of a 401(k) loan interest rate and other details. Generally speaking, you can borrow up to 50% of your vested account balance, up to $50,000, with a lower interest rate than a traditional loan. This makes 401(k) loans reasonably affordable compared to alternatives.

To take out a 401(k) loan, you apply with your plan's administrator, who arranges the distribution of funds and the repayment from your paycheck. Since this all goes through your employer, you’ll have to check to make sure the loan is available and the terms are solid. The standard replacement term is five years, but you can get a longer payback period if you use the borrowed funds to buy a home.

When to consider a 401(k) loan

As with any borrowing product, 401(k) loans have their own place and purpose. They’re a good option if you’re ready to buy a home or need the funds for another important purchase, like unexpected repairs.

Remember that you’re borrowing from your retirement fund. These loans aren't a replacement for credit cards, so don’t use them for regular purchases. And if you’re getting close to retirement, you might want to save the money for its intended purpose.

Advantages of 401(k) loans

Here are some of the benefits of 401(k) loans:

No credit check or lengthy application process

Because you're effectively borrowing from yourself, taking out a 401(k) loan doesn't impact your credit score or require a credit check. This reason alone makes these loans a good choice for people with lower scores. Plus, 401(k) loans also have a much shorter application process than traditional means of borrowing, allowing you to access the money quickly.

Low interest rates and penalties

In most cases, 401(k) loans offer more desirable interest rates — often prime plus a small premium. Since you're borrowing from yourself, the distributor doesn’t necessarily account for risk like a traditional lender would. And as long as you pay the money back on time, there aren't any fees, taxes, or penalties.

Repayment flexibility

While 401(k) loans have a maximum five-year payback period for all situations (except when buying a primary residence), you can typically define your own shorter repayment period. You can pay them back early without penalty, defer them during leaves of absence, and customize your payment frequency, making them much more flexible than traditional loans.

Risks of 401(k) loans

These loans have their own set of cons. Here are four risks to know about:

Failure to pay penalties

If you don’t pay back the loan within the repayment period, the distributor treats it as an early withdrawal (if you’re younger than 60). Early 401(k) withdrawals come with tax implementations and a penalty of up to 10%. Repaying the loan within the payback period is essential to avoid these costs, and if you can’t swing it, the loan may not be worth it in the first place.

Reduction in retirement savings

Borrowing from your 401(k) means reducing your savings during the payback period. But the more money you have, the more your investments grow. And that means the more you borrow, the less you’ll have by the time you retire.

Employer dependent

Retirement plans vary from employer to employer. While the IRS does outline some 401(k) requirements — like a minimum of quarterly payments and a maximum term of five years for general use loans — the rest of the program, including interest rate, is up to your employer. Your program administrator can provide details on your options, but everyone's access and experience with a 401(k) loan will be different.

Job loss risk

Since 401(k) loans are run through your employer, they rely on your continued employment. In many situations, resignations, terminations, and layoffs can mean a person must repay the loan in full. Some plans do allow for a rollover to an IRA or another qualifying retirement plan to avoid the need for immediate repayment, but this isn't guaranteed.

5 alternatives to borrowing against your 401(k)

If you prefer not to borrow from your retirement savings, here are some other options:

1. Emergency savings. Using your emergency savings is usually better than taking out a loan, depending on the situation. While it lowers the amount of money you have in the bank, you don’t have to pay it back like you would a loan.

2. Personal loan. Another borrowing option is to take out a personal loan with a lender. Personal loans are likely more expensive than borrowing from your 401(k), but they won’t impact your retirement savings, and you have more control over amounts and repayment plans. Beware though: that interest can become a debt trap.

3. Cash advance. Cash advances let you borrow money in the short term from your credit card. Interest rates are usually high, but advances are quick and easy to access. If you don’t need a lot of money and can pay it back quickly, cash advances are better than borrowing from your 401(k).

4. HELOC. A home equity line of credit, or HELOC, is a type of loan where you can borrow money against the equity of a home you own. HELOCs usually charge more interest than a 401(k) loan, but less than a personal loan or cash advance, making them a middle-of-the-road option. Just keep in mind that you’re using your home as collateral, which gets risky if you can’t repay.

5. Earned Wage Access. Instead of borrowing money or using credit with interest, use a same-day pay app like EarnIn to access your own money as you earn it. This gives you more flexibility with your money if you need access to it before your paycheck arrives, and with EarnIn it comes with no interest, no credit checks, and no mandatory fees — and it doesn’t touch your hard-earned retirement fund.

Frequently asked questions

Still not sure if a 401(k) loan is worth it? Here are some FAQs:

Does my employer have to approve my 401(k) loan?

Yes, your employer must approve your 401(k) loan. Your plan administrator can give you the application and answer any questions you may have about the 401(k) loan program.

Can I pay off my 401(k) loan early?

Yes, in most cases, you can. Loan details vary between companies, but you can generally repay them early and make lump sum payments.

Is it better to borrow against or withdraw my 401(k)?

The answer to this question depends on a few factors. Generally, if you're under 60, you don't want to withdraw from your 401(k) because you'll be hit with penalties and taxes — borrowing is better. Once you're over 60, withdrawal is often the best choice, unless you're still earning a high salary.

Need cash quickly? EarnIn has your back

If you need access to money quickly, EarnIn's Cash Out tool can help.

Cash Out lets you access your pay as you work — up to $100/day and up to $750/pay period — so you don’t have to borrow against your 401(k) or even take out a loan. Instead, you access your earned wages without risking your financial future.

Download the EarnIn app today and experience money at the speed of you.

Please note, the material collected in this post is for informational purposes only and is not intended to be relied upon as or construed as advice regarding any specific circumstances. Nor is it an endorsement of any organization or services.

1. EarnIn is a financial technology company, not a bank. Banking services are provided by our bank partners on certain products other than Cash Out. Subject to your available earnings, Daily Max and Pay Period Max. EarnIn services may not be available in all states. Restrictions and/or third party fees may apply, for more information please visit http://EarnIn.com/TOS.