401(k) Loans: What It Is, And How They Work

Written by Kim PinnelliUpdated: 18th Feb 2022
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Borrowing from your 401K is like borrowing from your future. You set money aside to help you during retirement, but you reduce those earnings when you take the funds out early.

401K loans are often easy to get, but they aren’t always the right answer. Here’s everything you must know about 401K loans and how they work.

What Is a 401(K) Loan?

A 401K loan is a loan against your 401K account. It’s like borrowing from yourself. You don’t need approval, and you pay the loan back like you would any other loan. More than ¾ of retirement plans allow you to take loans from your 401K but knowing how it works is important.

How Do 401(k) Loans Work?

Like any personal loan, you must apply for a 401K loan. Only you aren’t applying at a bank or through a lender. You apply through your 401K plan sponsor.

The requirements vary by the sponsor, so ask about the details from your sponsor so you understand the repayment terms, interest rate, and any other rules they may have. You are in control of the term (up to 5 years is the law) and how much you repay at a time.

You’re essentially paying yourself back with interest since you pay interest on the money you borrow. So, it’s not a ‘free loan.’ It’s borrowing from yourself and paying yourself back with interest.

401(k) Loan Rules, Regulations, and Requirements

Like any loan, there are rules, regulations, and requirements you must follow. Like we said earlier, each plan has different loan requirements, but overall, here’s what you should know.

How Much Can You Borrow from Your 401(K)?

By law, you can borrow 50% of your VESTED balance or $50,000, whichever is less. Your vested balance is the amount you would walk away with if you were to leave your job. Each plan has a different vesting period, so pay attention to the time your money must be in the account for you to be considered vested.

While you could borrow up to $50,000, you might not want to as that’s a lot to pay back. It also risks the potential loss of a lot of earnings.

401(k) Loan Repayment Terms

You can set your own repayment terms, but you must repay the full amount within five years. You can set up repayment through payroll deductions and can set them up weekly, bi-weekly, monthly, or even quarterly.

However, if you leave your job, the full amount becomes due and payable right away, so keep that in mind.

401(K) Loan Fees

You’ll pay interest on your 401K loan like you would for any other loan, but you’re paying yourself. Don’t let it fool you into thinking you aren’t missing out on earnings, though. The interest you’ll pay typically won’t be as much as you would have earned in your investment accounts with your earnings compounding.

Always ask what interest rate you’ll pay. Most providers use a benchmark, such as the prime rate, and add a margin to it.

>> More: What Is a Personal Loan Origination Fee?

What Are the Advantages of 401(K) Loans?

Easy to get

You don’t have to jump through hoops to get a 401K loan. As long as you are vested and your plan allows loans, chances are you’ll get approved. You don’t need a specific credit score or debt ratio to qualify.

You pay yourself interest.

Rather than paying a bank interest, you pay yourself. The money goes directly back into your 401K to continue growing for your retirement.

Interest rates are low.

Interest rates on 401K loans are typically much lower than interest rates on a consumer loan. So not only do you pay yourself, but you pay less interest than you would for any other loan option.

What Are the Disadvantages of 401(K) Loans?

If you leave your job, the loan is due and payable

Unlike a traditional loan, keeping your job is the only way to stop the loan from becoming due and payable right away. If you aren’t sure if you’re staying at your job, it’s best to avoid a 401K loan.

You deplete the compound earnings.

When you take money out of your 401K, you lower your earnings and eventually your compound earnings. If you keep the money out for the full five years, you could seriously limit your retirement account growth.

You can’t make contributions to it while you have a loan

Most plans don’t allow you to contribute to your 401K while you have an outstanding loan. This further depletes your efforts to save enough money for retirement.

How to Get a 401(k) Loan (Step-by-Step)

#1. Ask Your Employer

Ask your employer about the option for a 401K loan. You may have to talk to your Human Resources department or the plan administrator. Read your plan documents or log into your account online to see what options you have, if any.

#2. Know Your Options

Find out what terms the plan sponsor will allow. Like we said earlier, every plan has different requirements and allowances. You may have options for the loan term, repayment options, or even interest rate. Compare all your options side-by-side to find the most attractive one.

Compare your 401K loan options to other options, such as a personal loan, credit card, or even a home equity loan. Look at the total cost and what you’re giving up by taking money out of your 401K.

#3. Review the 401(k) Loan Terms

Look at the big picture. Don’t just take the money because you can. Understand what it will cost you in interest and what you’re giving up by taking money out of your 401K now. Make sure you can afford the repayment terms too.

#4. Receive Funding

Once you complete the paperwork and it’s approved, you’ll receive your funds as one lump sum. Put the funds in a safe place and if you aren’t using them all at once, try putting them somewhere where you can earn interest to offset the interest you’ll pay for the loan.

#5. Make Monthly Payments

Your plan administrator will set up the payments, typically automatic withdrawals from your paycheck. This ensures that you won’t miss a payment and fall behind.

Should You Get a 401(k) Loan?

A 401K loan isn’t the best idea if you have other options. Because you decrease your retirement account balance, you decrease your earnings. This could make it harder to reach your retirement account goals, putting you in jeopardy of financial troubles during your golden years.

On the other hand, if you have bad creditand are in over your head in debt, a 401K loan may be just what you need. You can’t ‘out earn’ the interest you pay on high-interest consumer debt, so it might make sense to take the money out, get out of debt and then focus on repaying your retirement account.

It all depends on your plan’s terms and what they’ll allow. Don’t assume every 401K loan is good – read the terms and find out for sure.

Is a 401(k) Loan or Withdrawal Better?

A 401K withdrawal is different than a 401K loan. A withdrawal means you take the money out and don’t repay it. If you take the money before you turn 59 ½ years old, you’ll pay a 10% penalty plus taxes at your current tax rate.

If you’re over 59 ½, you’ll just pay taxes at your current rate. If you’re not retired yet, a loan makes more sense since you’ll avoid the 10% penalty and pay yourself interest. But, if you’re retired, you’ll avoid the 10% penalty and won’t have to worry about paying yourself back.

The only exception to the 401K withdrawal penalty is if you qualify for a 401K hardship withdrawal. A hardship withdrawal is up to the plan sponsor, who decides if your emergency is a true emergency worthy of a hardship withdrawal.

Can You Use a 401(K) Loan for Anything?

You can use the proceeds from a 401K loan for anything you want. They don’t tell you what you can and cannot use the funds for. This is unlike a hardship withdrawal which would require you to prove why you need the funds to determine if they qualify as a hardship.

Are 401(K) Loans Safe to Use?

Like any loan, 401K loans have their risks. While it’s perfectly acceptable to borrow from your funds, there’s always the risk that you won’t be able to make your payments. If you don’t, the money could be subject to the 10% penalty and taxes because the IRS will consider it a distribution versus a loan.

If you can afford the payments, you can keep the term short, and you plan on staying at your job at least until you pay the loan off, then it can’t hurt except for the loss in earnings you might have.

>> More: Best Short-Term Loans

Bottom Line: 401(K) Loans

401K loans probably shouldn’t be the first place you look when you need money, but they shouldn’t be completely overlooked. Talk to your plan sponsor about the loan’s terms, interest rates, and what you must do to qualify.

Also, try exhausting any other loan options you might have, like a personal loan or home equity line of credit. Compare the interest and terms to decide which option is the least expensive for you.

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Kim Pinnelli
Kim Pinnelli

Kim Pinnelli is a Senior Writer, Editor, & Product Analyst with a Bachelor’s Degree in Finance from the University of Illinois at Chicago. She has been a professional financial writer for over 15 years, and has appeared in a myriad of industry leading financial media outlets. Leveraging her personal experience, Kim is committed to helping people take charge of their personal finances and make simple financial decisions.