401(k) Loans: What You Need to Know Before Borrowing

FT Contributor
A person taking money out of a jar marked "Roth IRA."

When you have a financial hardship — for instance, you’ve run through your savings after losing a job, or you’re facing a particularly large unexpected expense — the money you’ve saved for retirement in your 401(k) plan may seem like a viable option for some much-needed cash. After all, if you have 30 to 40 years left before you retire, taking out a few thousand dollars now might not seem like that much of a setback.

Because financial hardships are common, many 401(k) retirement accounts allow account holders to borrow from their savings in specific circumstances. In some cases, a 401(k) loan may be your only option to get the cash you need. However, there are some major caveats that come with one of these loans, and generally speaking, they should only be a last resort in a true emergency. Before you turn to your retirement savings for a bailout, there are some important rules and things to know.

Table of Contents

How 401(k) Loans Work

When you take out a 401(k) loan, you are borrowing money from yourself, with interest. Because you’re taking the money out of your retirement account before you qualify to retire, it’s not considered a disbursement, but rather a true loan that needs to be repaid.

With this in mind, the first thing to do when you want to borrow money from your 401(k) is determine whether your plan will actually allow you to do so. Not all plans allow loans, while others might allow multiple loans. You can ask your account administrator for information, or check your plan documents to find out whether you can access your money.

If your plan allows loans, you cannot simply request any amount and repay it when you have the money. You have to adhere to some very specific guidelines.

Maximum 401(k) Loan Amount

The amount you have saved in your 401(k) account determines how much you can borrow. Federal law allows individuals to borrow up to

  1. The greater of $10,000 or 50% of their vested balance, or;
  2. $50,000, whichever is less.

Your vested balance is the amount of the money in the account that is actually yours. When your employer makes matching contributions to your retirement account, they set parameters for when you get to actually keep those funds, usually tied to how long you work for the company.

For instance, your employer may require you to stay with the company for at least one year before the matching contributions are vested. Because you can only borrow 401(k) funds that are vested, you may be limited even further as to how much you can actually access.

Maximum 401(k) Loan Term

The government also restricts 401(k) loans to a maximum term of five years, meaning you’ll need to repay the entire loan amount, with interest, within that period. The only exception to this rule is when you borrow money from your 401(k) for a down payment on a home. Some plans will allow a longer repayment period, in some cases as long as 25 years, on those specific loans.

Repaying a 401(k) Loan

Repayments on 401(k) loans are made via payroll deductions — no exceptions. Depending on the plan rules, those payments may be made every pay period, monthly or quarterly. The payments include principal and interest, which is typically the prime interest rate plus 1%. You may also be able to pay off the loan more quickly, without penalty.

How Do You Apply for a 401(k) Loan?

If your plan allows you to take out a loan, your plan administrator will help you complete the paperwork. This usually includes:

  • Determining how much you are eligible to borrow.
  • Determining the interest rate and overall interest charges.
  • Determining the repayment amount and schedule.
  • Requesting the loan.

Most of these steps can be accomplished online, via your 401(k) plan’s automated system. Typically, the application process will automatically tell you how much you can borrow and at what terms. Once you complete the application and sign the loan agreement, the money will be paid directly to you. It may be included in your next paycheck, or immediately deposited into your checking account, depending on your plan procedures.

Keep in mind that some 401(k) plans have minimum loan amounts, and may require your spouse’s consent if you are married and requesting more than $5,000. Note also that loans are different from hardship withdrawals, which have a different set of criteria and application process.

Why You Should Get a 401(k) Loan vs a Personal Loan

When you need an influx of cash, a 401(k) loan may be more appealing than applying for a personal loan for several reasons. For starters, you’re borrowing money from yourself, not a bank. This means that the loan will not affect your credit. Not only does getting one of these loans not require an inquiry into your credit, the actual loan itself won’t appear on your credit report and increase your debt to income ratio.

Pros of Getting a 401(k) Loan

The fact that 401(k) loans don’t affect your credit history is only one benefit. Other pros of these loans include:

  • Low cost compared to other loans: Not only are the interest rates lower, but you won’t be charged the fees that often come with personal loans. The interest rate is also usually much lower than using a credit card to cover unexpected expenses.
  • Fast access to cash: When you apply for a 401(k) loan, you typically have your money within a few days, delivered right to your account.
  • A temporary fix: If you only need short-term help to get through a temporary period of financial instability, and you expect to repay the loan quickly, a 401(k) loan won’t have a long-term effect on your credit history.

Cons of Getting a 401(k) Loan

Although there are some pros to a 401(k), the downsides can often outweigh any benefits. If you’re considering a loan, keep these cons in mind:

  • Missed opportunity for investment growth: When your money isn’t in your 401(k) account, it’s not earning interest and working for you. Even when you repay the balance with interest, you’re still setting back your interest earnings.
  • Reduced contributions: Some plans will not allow you to make contributions to your 401(k) while you’re repaying a loan. If you take the full five years to repay the balance, that means five years of missed contributions.
  • Repayment demands: If you leave your job while you still have an outstanding 401(k) loan, the plan administrator may require immediate repayment of the entire remaining balance. This applies even if you are fired or laid off.
  • Possible penalties: If you don’t repay the loan as agreed, the loan could ultimately be treated as an early disbursement if you took the money before you were 59.5 years old. This means paying a 10% early distribution penalty, as well as federal income taxes on the amount you withdrew.
  • You can only borrow from a current 401(k): If you have a 401(k) with a former employer that you never rolled over into your new employer’s plan, you cannot borrow that money. According to the IRS, you also cannot borrow any cash from an IRA plan. Loans are strictly limited to funds in your most current 401(k) account.

If you decide to take a loan from your 401(k) plan, it’s important that you know all of the potential pitfalls, and use the money wisely. Take time to compare the 401(k) loan to other options like personal loans and home equity loans to ensure you’re making the right long-term decision.

It can be dangerous to use a 401(k) loan to repay debt, for instance, because you’re not only losing out on market gains, but also the protection from creditors that a 401(k) provides. Remember that the money you spend from your retirement account now is money you won’t have in the future, so avoid making decisions today that could take years to recover from.

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