401(k) Loan vs. Personal Loan

When you need to borrow money for debt consolidation, home improvements, medical bills or other major expenses, a 401(k) loan and a personal loan may both be options. A 401(k) loan lets you borrow against your retirement savings and repay the money, plus interest, to your account. A personal loan, by comparison, allows you to borrow from a bank, credit union or other lender without taking money out of your retirement plan. While a 401(k) loan may offer easier qualification and potentially lower borrowing costs, it can interrupt the growth of your retirement savings and create tax consequences if it isn’t repaid as required.

A financial advisor can help you compare borrowing options and consider how taking on debt could affect your budget, retirement savings and long-term financial goals.

What Is a 401(k) Loan?

A 401(k) loan is a loan you take out against the balance in your 401(k) plan at work. Not every employer allows 401(k) loans. And those that do may have specific rules regarding what you can borrow. But typically, you can take a 401(k) loan of up to $50,000 or 50% of your vested balance, whichever is less.

So, what can you use a 401(k) loan for? The good news is that these loans are flexible, meaning you can use the money for virtually any purpose, including:

Funding home renovations or repairs
Paying for a down payment on a home
Consolidating high-interest debt
Covering outstanding medical bills
Paying higher education expenses for yourself, your spouse or children
Paying medical bills
Starting a business
Covering day-to-day living expenses

The maximum repayment term for a 40k(k) loan is up to five years. When you take out a 401(k) loan, you have to pay it back with interest. However, you are paying that interest back into your own retirement account, rather than to a lender.

The interest rate on these loans is often well below what you’d pay with a credit card or other types of loans. Repayment is typically made through paycheck deductions, so you can pay your loan balance down automatically each payday.

What Is a Personal Loan?

A personal loan is money you borrow for personal expenses. You can find personal loans offered by banks and credit unions or online lenders. Personal loans can be unsecured, meaning they don’t require any collateral. They may also be secured by a savings account balance or certificate of deposit (CD) account. This is usually the case with credit builder loans.

In terms of what you can use personal loans for, the list includes the same things you could use a 401(k) loan for. A popular use for personal loans is debt consolidation. If you have several credit cards with steep APRs, for example, you could get a low-interest rate personal loan to pay them off. You’d then make one payment to your personal loan lender going forward. The result is that you could save money on interest while potentially trimming some time off your debt repayment.

Personal loans do charge interest. The rate you’ll pay can depend on several factors, including:

How much you need to borrow
Your credit history, credit scores and income
The lender’s loan requirements

There’s no universally accepted minimum credit score that’s required for a personal loan. But the higher your credit score, the easier it may be to get approved and secure the best interest rates. A lower score may limit your options to bad credit personal loans, which can be more expensive.

Click Your State to Get Matched With Financial Advisors That Serve Your Area

Choose your state and answer some questions to get matched with up to three fiduciary advisors that serve your area.

How Much Could a 401(k) Loan Cost Your Retirement Savings?

The interest rate on a 401(k) loan doesn’t show its full cost. When you borrow money from your 401(k), that money sits outside your portfolio and misses market gains. A personal loan charges interest but leaves your retirement savings invested.

Consider borrowing $20,000 for five years. A personal loan with an interest rate of10% would cost about $5,500 in interest. That same $20,000 left invested at a 7% return on average would grow to $28,051, representing $8,051 in potential growth in your 401(k) plan.

$20,000 Borrowing Example	Estimated Amount
Personal loan at 10% for five years	$5,500 interest
$20,000 invested at 7% for five years	$8,051 growth

The $8,051 represents opportunity cost, not actual loss. Loan repayments go back into your account over time, and investment returns vary year to year. When comparing borrowing options, weigh the interest you’d pay against the growth you’d miss.

401(k) Loan vs. Personal Loan: Which Is Better?

Whether it makes more sense to choose a 401(k) loan or a personal loan can depend on how much you need to borrow and what you need the loan for. This is where it helps to weigh the pros and cons on both sides to see which one is better suited to your financial situation.

401(k) Loan Pros

Here are the most common benefits of a 401(k) loan:

You may be able to qualify for a lower interest rate than you could with a credit card or personal loan.
You’re paying interest back to yourself, rather than to a bank or lender.
There’s no credit check required, and a 401(k) loan won’t show up on your credit report.

401(k) Loan Cons

Here are the downsides of a 401(k) loan:

If you fail to repay a 401(k) loan, the entire balance can be treated as a taxable withdrawal under IRS rules.
Separating from your job may mean having to pay any remaining loan balance, often due in a lump sum.
Taking money from your 401(k) means you’re missing out on the power of growth through compounding interest.

A 401(k) loan can be convenient, but it’s important to consider the bigger picture in terms of cost. While you might not pay loan fees, you could be shortchanging your retirement savings by taking money from your plan. While you’re paying it back with interest, the interest you pay may be less than the interest your savings could have earned if you’d left it alone.

There’s also the possibility of having to pay income taxes or tax penalties on a 401(k) loan if you’re not able to pay it back in time. The IRS can treat the entire loan balance as a taxable distribution, and if you’re under age 59 1/2, a 10% early withdrawal penalty also applies. This could make a 401(k) a very expensive way to borrow, depending on how much you take out and which tax bracket you land in.

Personal Loan Pros

Here are the most common personal loan benefits:

You can borrow money without taking anything away from your retirement savings.
Personal loans can offer flexible repayment terms to fit your budget.
A good credit score could help you to qualify for a low interest rate.

Personal Loan Cons

Here are the most common personal loan downsides:

You’re paying interest to a lender, and the higher the rate, the more you’ll pay over time.
Some personal loans may charge origination fees or prepayment penalties if you decide to pay the loan off early.
The amount you could borrow with a personal loan may be less than what you could get with a 401(k) loan.

Personal loans allow you to get funding when you need it without shrinking your retirement savings. And if for some reason you can’t repay the loan on time, you don’t have to worry about the IRS assessing tax penalties.

But it’s important to shop around and compare personal loan lenders before you borrow. Specifically, it’s helpful to look at loan repayment terms, loan limits, credit score requirements, interest rates and fees before committing to a lender. You can also take time to calculate your estimated personal loan payments to get a feel for how well it will work for your budget.

Bottom Line

Whether you choose a 401(k) loan or a personal loan to meet your borrowing needs is an important decision because of how it can affect your retirement savings. If you have the option to qualify for a personal loan at a low interest rate, consider how much you’ll pay versus how much growth you could be missing out on by choosing a 401(k) loan instead. This can help with deciding which loan option makes the most sense.

Retirement Planning Tips

Consider talking to a financial advisor about whether it’s better to take a 401(k) loan vs. personal loan when you need funding. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
If you’re experiencing financial hardship, you might consider whether a hardship withdrawal from your 401(k) is a good idea. Not every employer allows hardship withdrawals. And among those that do, you’ll need to meet certain requirements to qualify. But taking a hardship withdrawal means you wouldn’t have to pay the money back, though you would still be subject to taxes.