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

If you’re facing an unexpected expense you can’t cover with your savings, you might be tempted to borrow from your retirement account. It could be a good option in some circumstances, but 401(k) loans come with serious risks and drawbacks. 

A personal loan might be a better option if you need a large loan or a long repayment term. If you have good credit and can qualify for a low rate on a personal loan, you might also build more wealth if you leave your retirement account alone and intact. Here’s how to decide which type of loan is best for your financial situation. 

401(k) loan vs. personal loan

Brief overviews of each funding option

How personal loans work

You can apply for a personal loan at a bank, credit union, or online lender. If approved, you’d receive a lump sum of cash in your bank account — often within a few business days. You’d repay the loan in equal monthly payments over several years. In most cases, you won’t need to provide an asset as collateral, and the application process is quick and easy.

Most lenders cap loan amounts at $50,000 or $100,000, though some offer larger loans — for example, BHG Financial offers personal loans up to $250,000. Personal loan APRs are lower than credit card APRs on average. The APR (annual percentage rate) reflects the annual borrowing cost, including upfront fees and interest. But the loan amount and APR you qualify for depend on your income, credit score, and other factors. 

How 401(k) loans work

Not all 401(k) plans permit loans, but you can find out if yours does by contacting your plan sponsor. Rules vary from one plan to the next, but you can typically borrow up to $50,000 or 50% of your vested balance, whichever is less. There’s an exception if 50% of your vested balance is less than $10,000, in which case you can borrow up to $10,000. 

You must repay the loan within five years, unless you use the cash to buy a home that will be your principal residence. And you need to make equal payments with interest at least quarterly, typically through payroll deductions. If you leave your job before paying the balance entirely, the remainder could become due immediately. If you can’t pay, the loan could be treated as a distribution — which means you’d owe income tax and, if you’re under age 59 ½, a 10% early withdrawal penalty (unless you can qualify for an exception). 

Similarities and differences

Similarities of personal loans and 401(k) loans

• Lump sum disbursement: 401(k) loans and personal loans both provide the loan funds as a lump sum, unlike a credit card or line of credit, which allow ongoing borrowing. 
• Repayment in fixed installments: 401(k) loans and personal loans are both repaid in fixed installments at regular intervals. Personal loans feature monthly payments with the option to make extra payments. 401(k) loan payments may be weekly, bi-weekly, monthly, or quarterly, depending on the plan. In any case, you’d know what to expect and how much to budget for repayment. 
• Possible fees: Depending on the lender or plan, personal loans may require an origination fee, which is an upfront fee that’s often a percentage of the loan amount. 401(k) plans may charge origination or administrative fees as well, but these tend to be a one-time flat fee up to $100, as opposed to a percentage of the loan amount. 
• Flexible use of funds: You can use a personal loan or 401(k) loan for a wide variety of personal expenses, from debt consolidation to home improvement. That said, personal loans tend to have more restrictions than 401(k) loans — for example, you can use a 401(k) loan to buy a house or pay for college, while most personal loan lenders prohibit those uses. 
• Funding: “If the employee's 401(k) plan allows for a 401(k) loan, typically the loan can be processed quickly with most large recordkeepers,” says Lisa Cummings, attorney and Executive Vice President at Cummings & Cummings Law. Personal loans typically provide funding within a few business days, with some lenders offering funding as soon as the same day. 
• Repayment terms: 401(k) loan repayment terms are 5 years in most cases, but the term could be cut short if you leave your job. Personal loans often feature repayment terms up to 7 years, though some lenders offer longer terms. 
• Loan amounts: Like many personal loans, the maximum 401(k) loan amount is $50,000 — though if you have a much smaller vested balance in your 401(k), you could access more money with a personal loan.

Differences between personal loans and 401(k) loans

• Eligibility requirements: Personal loan lenders evaluate your credit score, income, and existing debts. Requirements vary, but most lenders require at least a fair credit score. 401(k) loans, however, are no-credit-check loans. But you must be an active employee with a 401(k) plan that allows loans. Depending on the plan, there may be other requirements as well — in some cases, your spouse may need to consent to the loan. 
• Interest rates: 401(k) loans tend to have lower interest rates than personal loans, and the interest is paid to your retirement account rather than a lender. However, a personal loan is preferable if you can qualify for a rate that beats your expected return on your 401(k) balance. 
• Tax consequences: If you default on a 401(k) loan or otherwise fail to comply with the terms, you could owe income tax on the loan amount plus a 10% penalty. Additionally, “Some plans may not allow you to contribute to your 401(k) until the outstanding loan is paid in full,” says Alajahwon Ridgeway, owner and Financial Advisor at A.B. Ridgeway Wealth Management. “If there is a restriction, this will limit your tax deduction for 401(k) contributions and potentially increase your adjusted gross income.” Personal loans don’t have tax consequences unless the loan is forgiven.

Impact on credit

How personal loans affect your credit score

A personal loan may affect your credit score both positively and negatively. When you apply, most lenders run a hard credit check, which typically causes a decrease in your credit score. For most people, the decline is less than five points. If you repay your personal loan responsibly, your credit score can improve in the long run.

A personal loan benefits your credit score in a few ways:

• If you don’t have other installment loans like an auto loan or mortgage, a personal loan will add to your credit mix, potentially improving your score. 
• If you use the personal loan to consolidate credit card debt, it will reduce your credit utilization ratio, an important factor in improving your FICO score. 
• If you make all personal loan payments on time, you’ll positively impact your payment history, a factor that comprises 35% of your FICO score. A strong payment history goes a long way toward improving your credit score. 

On the flip side, late or missed payments will damage your credit. A new loan will also affect the average age of your accounts. Before applying for a personal loan, it’s a good idea to check your credit score to see where you stand. 

How 401(k) loans affect your credit score

“A 401(k) loan doesn’t appear on your credit report, so it generally won’t affect your credit score — good or bad,” says Melissa Cox, owner and Certified Financial Planner at Future-Focused Wealth. “That’s a plus for someone trying to avoid a hard inquiry or who already has a lot of credit activity.”

It also means you can qualify with bad credit (because your credit score is not a factor in getting a 401(k) loan). It’s challenging to get a personal loan with bad credit. If you do, you can expect a high APR. 401(k) loan interest rates aren’t dependent on your credit score. The downside of a 401(k) loan is that it won’t help you build credit. Defaulting on a 401(k) loan also won’t impact your credit score (but you’ll face tax consequences). 

Examples of when either option is a better choice

Scenarios when personal loans make more sense

1. Your 401(k) plan doesn’t allow loans. 
2. You need a larger loan or a longer repayment term. 
3. You might leave your job within 5 years.
4. You can qualify for a personal loan APR under 10%.
5. You don’t want to lose the ability to make tax-deductible contributions.

Scenarios when 401(k) loans make more sense

• You can repay the loan in 5 years or less.
• You can’t qualify for other loan types.
• You have a secure job and a repayment plan in place.
• You want to avoid impacting your credit. 
• You’re not at risk of filing for bankruptcy.

Alternative funding options to consider

$1,000 emergency 401(k) withdrawal

If you only need $1,000 for an emergency expense, 401(k) and other retirement plans allow you to withdraw up to the lesser of $1,000 or your vested account balance over $1,000 each calendar year. In other words, if your vested account balance is $1,800, you could withdraw up to $800 for an emergency expense. You’d still have to pay income tax on the amount withdrawn but can avoid the 10% early withdrawal penalty. 

Hardship distribution

Your plan may allow a hardship distribution in the amount necessary to meet an “immediate and heavy financial need.” Certain circumstances are exempt from the additional 10% tax penalty, but the distribution is still subject to income tax in the year you receive it.

“Many times 401(k) plans will actually require the employee to attempt to take a plan loan before they are eligible for hardship withdrawal,” says Cummings. Loans are generally preferable, since they don’t impose a tax burden if repaid, and they don’t permanently reduce your account balance. However, Cumming says a 401(k) hardship distribution may be a better option if you plan to leave your job or if repayment would put you in financial distress. 

Home equity loan or HELOC

Home equity loans and home equity lines of credit (HELOCs) are secured by your home equity, or the share of your home that you own outright. A home equity loan provides a lump sum of cash, while a HELOC allows you to borrow repeatedly up to a limit.

Because both options are secured by your home as collateral, they typically come with lower interest rates than personal loans. But there’s a risk of foreclosure if you fail to repay, and you’ll generally need at least 15% home equity to qualify. 

Credit cards

Credit cards are great for recurring purchases that you can repay within your credit card’s grace period. Some credit card issuers also offer 0% APR promotions, which may allow you to make a large purchase or transfer debt from other credit cards and avoid interest on the balance for up to 21 months. But you’ll need to keep up with minimum payments. Be sure to pay off the balance before the promotional period ends and the card's regular APR goes into effect.